A Study of
Informal Finance Markets
in Pakistan
Prepared for the Pakistan Microfinance Network
By Adnan Qadir
A STUDY OF INFORMAL FINANCE MARKETS
IN PAKISTAN
Adnan Qadir
with a study of SMEs by Dr. Faisal Bari and Adeel Faheem
and a survey by the Punjab Economic Research Institute
Pakistan Microfinance Network
©2005 Pakistan Microfinance Netowrk
First printing in December 2005
The findings, interpretations and conclusions
expressed in this study are those of the authors
and should not be attributed in any manner to the
Pakistan Microfinance Network (PMN),
or its board of directors.
The Pakistan Microfinance Network encourages
use of the material presented herein, with appropriate
credit.
Pakistan Microfinance Network
nd
2 Floor, Block 14, Civic Center
G-6, Islamabad, Pakistan.
Tel: (92-51) 2824788, 2279015
Fax: (92-51) 2824945
E-mail: info@pmn.org.pk
ABBREVIATIONS
Accumulating Savings and CreditAassociations
ASCRAs
Bonded Labor Research Forum
BLRF
Committee on Rural Finance
CRF
Development Finance Institutions
DFIs
Integrated Development and Entrepreneurship
Advisory Services
IDEAS
Informal finance markets
IFMs
International Food Policy Research Institute
IFPRI
Microfinance Institutions
MFIs
National Human Development Report
NHDR
Punjab Economic Research Institute
PERI
Pakistan Institute of Development Economics
PIDE
Pakistan Microfinance Network
PMN
Punjab Small Industries Corporation
PSIC
Rotating Saving and Credit Associations
RoSCAs
State Bank of Pakistan
SBP
Small and Medium Enterprises
SMEs
Small and Medium Enterprise Development Authority
SMEDA
Zarai Taraqiati Bank Limited
ZTBL
Executive Summary
Overview
Informal finance markets (IFMs) have a long history pre-dating
formal markets and a strong presence in most of rural and urban Pakistan.
The informal financial sector is that part of the economy in which financial
contracts and agreements are conducted without official regulation or
monitoring.
In one view, these markets exist because financial markets as a
whole are incomplete and with their expansion, informal markets would
cease to exist. Another view maintains that the informal sector does not
just exist due to the limitations of the formal markets but has a
comparative advantage in some market segments. Informal institutions
either provide services that formal institutions cannot provide or have a
cost advantage over their formal counterparts. Indeed, some part of the
demand for informal finance comes from the desire to operate outside the
formal, documented economy in order to avoid paying taxes and is
sometimes linked to the underground economy.
However, urban IFMs and small and medium enterprises (SMEs)
face constraints in getting access to institutional credit. Bari and Faheem
report for this study that SMEs are 'credit constrained' in the sense that
while they are willing to borrow and/or borrow more at prevailing interest
rates, they do not have access to funds and thus get credit rationed.
Lack of well-functioning financial markets has disproportionately
adverse consequences for the poor who have credit requirements but few
assets that can serve as collateral. They are thus shut out of formal finance
markets and this perpetuates poverty. Richer rural households have better
access to cheaper institutional credit whereas poorer households depend
mainly on expensive informal or non-institutional sources.
Informal markets cannot be strictly classified. They are generally
stand-alone markets operating without the links that characterise wellintegrated financial markets. The multiplicity of informal finance markets
is reflected in the observed diversity of transactions in these markets, such
as lending and borrowing among close relations, rotating saving and credit
i
The lack of wellfunctioning
financial markets
has
disproportionately
adverse
consequences for
the poor who
have credit
requirements but
few assets that can
serve as collateral.
associations (RoSCAs), moneylending, interlinked financing and suppliers'
credit, among others
Urban financial markets are different from rural ones in certain
important respects. Many urban markets catering to traders, especially
wholesalers, have a long history and are quite well developed in terms of
the amounts of funds intermediated, the speed and efficiency of the
intermediation and the sophistication of participants as well as the market
as a whole.
Suppliers' credit is a common feature: in old markets with
established players, as much as 90 per cent of transactions are carried out
on suppliers' credit resting on good faith. A chit (parchi) is the norm for
making business transactions and is not dishonoured; it represents a
convenient and flexible method that allows business to be conducted at
arms-length and does not require documentation or entail tax liabilities.
Informal finance markets are very common in the transport
business. In some urban areas, moneylenders mostly provide credit in the
shape of goods to clients. The annual interest rate for credit in the shape of
goods varies depending on the financial position of the borrower and his
previous track record. Default rates in transport financing are said to be
very low because social linkages help overcome screening and monitoring
problems, reduce the risk of default and ensure availability of multiple
channels in case of repayment problems. Similar patterns were observed in
the shoemaking industry and in the dairy and livestock industry in different
cities and different markets.
Informal savings
Savings are needed by all households for smoothing income and
consumption flows but are especially vital for the poor. Being rationed out
of the formal credit markets, they need savings for risk mitigation and for
making productive investments in their farms or informal enterprises. The
poor save in a variety of financial and non-financial forms and their
primary need is to swap small savings flows for lump sums. The
Committee on Rural Finance suggests that savings, though available in
In old markets
with established
players, as much
as 90 per cent of
transactions are
carried out on
suppliers' credit
resting on good
faith.
ii
A Study of Informal Finance Markets in Pakistan
Pakistan's rural areas, are not being tapped due to a lack of institutional
channels. As a result, people in rural areas save through traditional
channels.
Saving in livestock, that can be bought and sold when needed, is a
good livelihood diversification strategy for low-income households.
Livestock is also kept through share leasing which is a saving arrangement
between landlords and professional strata (kammis). Other traditional
saving arrangements in Punjab are called vartan bhanji and wanghar, meaning
asking others for help on a voluntary and reciprocal basis. Hoarding gold
and silver is also common in rural and semi-urban areas. Traditionally such
jewellery is supposed to be kept for a lifetime and transferred to the
children, only to be utilised as a last resort through sale or mortgage.
Informal fransfers
Informal transfers involve transfers or exchanges between
households of cash, food, clothing, informal loans and other informal
assistance. While informal transfers help the poor in risk management,
they are not adequate substitutes for public action in social protection.
A popular informal system of transferring money around the
world is the hawala system, marked by low commissions, fast transactions,
little documentation and round-the-clock operations. The system works
through individual "brokers" or "operators" collecting funds at one end of
the payment chain and others distributing the funds at the other end. The
hawala system has gained prominence following the 9/11 attacks in the US
as a major factor in money-laundering, financial crimes and financing of
criminal and terrorist organisations.
Rural finance
In rural areas - despite the expansion of institutional and policydirected credit - informal markets still supply most of the credit needed by
the poor because the banking sector is concentrated in and services
primarily urban and industrial needs. Credit in the rural areas is mostly
supplied by aartis (commission agents) and other middlemen at high
interest rates through interlinked transactions. The acute shortage of
iii
A popular
informal system
of transferring
money around
the world is the
hawala system,
marked by low
commissions,
fast transactions,
little
documentation
and round-theclock operations.
capital at affordable rates severely constrains the growth of the rural
economy and prevents efficient resource mobilisation and risk
management.
Characteristics of informal finance markets
The fundamental feature that creates imperfections in credit
markets is informational constraints regarding the use to which a loan will
be put as well as the repayment decision. All the important features of
credit markets can be understood as responses to one or the other of these
information problems.
Informal markets are generally characterised by high interest rates
and a sizeable gap between lending and deposit rates. There is extreme
variability in the interest rate charged by lenders for similar loan
transactions. Informal finance markets are generally marked by low levels
of default due to social sanction, group sincerity, past history and repeat
transaction.
Informal
markets are
generally
characterised by
high interest
rates and a
sizeable gap
between lending
and deposit
rates.
Interlinked transactions are contracts made between the same pair
of individuals relating to exchange in more than one commodity or service
and are quite prevalent, especially in the labour market. While there are
some advantages for interlinked borrowers, such contracts are also highly
exploitative and these sometimes far exceed their benefits.
One form of exploitative interlinkage between credit and labour
markets exists through the system of peshgi (advance payment for workers)
which often produces debt bondage. This is usually disguised behind
seemingly legitimate and 'voluntary' economic transactions where in
addition to the transaction in the labour market, a worker also transacts
with the employer on the credit market, repaying the debt by working for
the creditor.
Informal credit markets are marked by widespread rationing; that
is, there are upper limits on how much a borrower receives from a lender.
Segmentation is another feature of informal credit markets. Typically, a
moneylender serves a fixed clientele, whose members he lends to on a
iv
A Study of Informal Finance Markets in Pakistan
repeated basis, and is extremely reluctant to lend outside this circle.
Contract enforcement mechanisms
Social sanction and market limitations are the most common
instruments for enforcement of contracts as well as the recovery of loans.
Resorting to the legal system of the country is fairly uncommon.
Moneylenders usually take various precautionary measures before taking
on a new client. These include the practice of dealing with the potential
client in other markets, extensive scrutiny of new clients and through small
“testing loans”.
In an environment of weak contractual enforcement, those
engaged in business, especially arms-length transactions, have to be very
discreet and often rely on individual goodwill and social pressure in the
absence of security (collateral). In cases of default, market associations
normally mediate and decide about receivables and payables and in
extreme circumstances dispose of assets. Social, political influence or,
when all else fails, the use or threat of use of force is also a potent
instrument for enforcing contracts or ensuring payment. In many urban
areas, there are now organised groups that offer their services for a fee to
force recovery.
Implications for policymakers and the microfinance sector
It is not possible to wish away informal finance markets.
Policymakers need to realise that so long as institutional finance has limited
access and does not fully meet the demands of the client, the informal
financial sector will continue to flourish. A better economic response to
the existence of such markets may be to develop more linkages between
the formal and informal markets, to speed up financial liberalisation and
encourage deepening of formal finance markets.
One response to recognition of the informational advantages of
informal financial markets can be to try and encourage them rather than
replace them by expanding formal finance to economic agents who are
likely to use these funds in informal markets. Another response is to
actually design and help expand microfinance institutions (MFIs) that will
v
Social sanction
and market
limitations are
the most
common
instruments for
enforcement of
contracts as well
as the recovery
of loans.
take advantage of local level information.
In terms of urban informal sector financing, access to credit is
only one of many constraints, most of which can only be addressed
through changes in the investment climate aimed at reducing the cost of
doing business. A study of informal finance markets can help MFIs
understand their market, develop their core niche, explore the options for
cross-subsidisation between markets and developing viable and demanddriven products and practices. This can help the sector outgrow its current
small outreach to a more sustainable size. But microfinance cannot be a
solution for all the financial intermediation needs of the poor. In the long
run even the sustainability of microfinance requires a shift away from a
supply focus to a demand-driven market system.
MFIs can also reap the advantages of clustering. Clustering
represents a mechanism for reducing the transaction costs of doing
business and obtaining access to credit either through financing
cooperatives/associations of cluster firms, or financing of individual
firms in clusters while using the cluster associations for generating external
economies. In Pakistan there is tremendous potential for MFIs to
collaborate with public or private agencies through targeted, competitive
and market-driven public interventions in upgrading existing clusters or
catalysing the growth of a new cluster. MFIs can collaborate with either
commercial banks or public agencies on cluster development programs.
In the long run
even the
sustainability of
microfinance
requires a shift
away from a
supply focus to a
demand-driven
market system.
The Pakistan Microfinance Network (PMN) can facilitate this
process by conducting studies on existing clusters and by suggesting
models of such collaboration. Another option for MFIs is to tie into the
entire suppliers' chain through institutions providing embedded services as
part of their business strategy or mission. Finally, MFIs have a unique
opportunity at present to venture into the area of SME lending by trading
on the soft information available with them by either renting out their
ability to use social collateral or by going into SME lending on their own. In
the first option, MFIs can become information providers to and/or
partners of banks and the second is for MFIs to go directly into SME
lending. This option carries higher risks but promises higher returns as well
vi
A Study of Informal Finance Markets in Pakistan
and implies a significant change in its organisational structure, client base
and priorities. This may not suit MFIs trying to reach the very poor but
could work well for MFIs that fund existing micro and small businesses.
The Pakistan Microfinance Network can take a lead in this initiative and
initiate a dialogue as well as further research their prospects.
vii
Contents
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Overview
The theory of informal finance markets
Underground economy
Size of the informal finance sector
Implications of IFMs for poverty
History of informal finance
Providers of informal finance
Urban finance
Informal savings
Informal transfers
Rural finance
Characteristics of informal finance markets
Contract enforcement mechanisms
Implications for policymakers and the microfinance sector
Notes
Bibliography
1
2
5
5
6
8
9
13
19
21
22
25
31
34
41
43
ANNEX A: Microfinance Institutions and Small and
Medium Enterprises
1.
2.
3.
4.
5.
Introduction
Trends and modes of financing SMEs
Constraints to SME finance
Implications for MFIs
Conclusion
49
49
50
56
60
65
Notes
References
66
67
Table 1: Sources of Finance
Table 2: Percentage of Manufacturing and Export SMEs that ever
Received Formal Bank Credit by Size and Age of Firm
Table 3: Advantages Due to Legal Structure vis-à-vis Approaching Banks
for Financing
Table 4: Size-specific Rankings of Financial Constraints
Table 5: Security Requirements for Bank Loans
Table 6: Firms' Expected Days (after applying) Required to Acquire Loan from Banks
52
53
ANNEX B: Survey of Informal Finance Market
1. Background
2. Objectives
3. Review of literature
4. Methodology
5. Results of Case Studies
6.
55
57
58
59
69
69
69
70
71
5.1. Auto-rickshaw market
5.2. Faisalabad yarn market
74
74
81
Rural informal credit market
83
References
96
Table 1: Sample-size Distribution
Table 2: Rental Rates in the Auto-rickshaw Market
Table 3: Annual Interest Rate Being Charged by Input Dealers on Different Inputs
Table 4: Interest Rate Being Charged Involving Input Dealers and Their Borrowers
Table 5: Reasons for Preference Towards Informal Borrowing
Table 6: Interest Rate Being Paid by Borrowers of
Informal Credit Market on Different Inputs
73
80
91
92
93
95
Figure 1: Typical Informal Credit Market
Figure 2: Interest Rate and Yarn Quality
Figure 3: Interest Rate by Type of Input and Type of Borrowing
80
82
95
A study of informal finance markets in Pakistan
1. Overview
Informal finance markets (IFMs) have a long history pre-dating
formal markets and a strong presence in most of rural and urban Pakistan.
Despite the spread of formal financial institutions, IFMs still cater to a
large segment of the population, especially the poor. This is both because
the development of the formal financial sector has been slow, and also
because IFMs are better placed to secure and utilise the micro-information
required for contract enforcement. However, these markets have many
limitations and provide only some financial services: they cannot thus
substitute access to the full range of well-functioning financial services
that could assist in overcoming the poverty trap. While the range of IFMs
is broad, they do have some common features which have major
implications for policymakers as well as microfinance institutions (MFIs).
A study of the credit constraints faced by somall and medium enterprises
(SMEs) also points to a potential role of MFIs in financing SMEs, a
potentially lucrative market.
This background paper has been written with the primary
purpose of mapping and documenting IFMs in terms of their extent,
diversity, mechanisms and operations. The paper has been commissioned
by the Pakistan Microfinance Network (PMN) to help better understand
such markets, analyse them from the perspective of the poor, indicate
future areas of research and highlight the implications and potential for
MFIs vis-à-vis these markets. So far, the outreach of the formal
microfinance sector in Pakistan is still relatively small compared to many
countries. One of the major factors limiting outreach is the focus on a
narrow range of products, mostly credit, largely ignoring the potential of
savings, insurance and leasing. A study of IFMs will not only give MFIs
new ideas to work with, but also knowledge about how others have used
their informational and institutional advantages to create larger roles for
themselves.
This report is based on a combination of primary and secondary
research. The primary research consisted of field visits to parts of the
Punjab, the NWFP and Sindh and employed semi-structured narrative
interviews, case studies, focus-group discussions and a survey of some
1
So far, the
outreach of the
formal
microfinance
sector in
Pakistan is still
relatively small
compared to
many countries.
requirements, long approval processes and, by what is perceived by many
clients as an uncooperative bank bureaucracy. Most SMEs operate through
self-financing or retained earnings because their unregistered status
technically restricts them from qualifying for credit from the formal
banking sector. In case the source is a relative or friend, more funds can be
raised at a lower cost and without collateral. Except for in the case of
liquidity shocks, small enterprises seldom turn to informal financial
sources because of the expected high costs of credit or the unreliability of
lenders.
Bari and Faheem report for this study that SMEs are 'credit
constrained' in the sense that while they are willing to borrow and/or
borrow more at prevailing interest rates, they do not have access to funds
and are thus credit rationed. SMEs do not approach formal sector financial
institutions very often and the smaller firms, even within the SME sector,
approach them even less. It seems that the legal structure or age of SME
firms has little or no bearing on their ability to obtain finance.
Manufacturing SMEs, however, find it easier to obtain finance
from formal sector institutions compared to firms from the service sector.
For those SMEs that have received loans from formal institutions, working
capital loans constitute a higher percentage than long-term fixed
investments. Supplier/buyer or trade credit forms a small part of their total
credit portfolio while personal sources, retained earnings from the
business, and loans from family or friends form the bulk of investment
resources. High-interest commercial but informal credit markets form a
negligible source of credit funds for SMEs.
SMEs do not
approach formal
sector financial
institutions very
often and the
smaller firms,
even within the
SME sector,
approach them
even less.
Business enterprises have fixed capital, working capital, as well as
consumption needs and part of this demand is met through informal
sources because of working capital constraints and the need for loans
which do not require collateral. Some part of the demand for informal
finance comes from the desire to operate outside the formal, documented
economy in order to avoid taxes. The maintenance of dual accounts, one
for the tax authorities and one for conducting business, is a widespread
practice as acknowledged by almost all the market players interviewed for
4
A Study of Informal Finance Markets in Pakistan
this study. The low levels of education of many entrepreneurs partly
explain their distrust of formal systems, their desire to function outside the
range of the government’s radar and keep businesses less documented and
transparent.
3. Underground economy
Some transactions in IFMs - especially in urban areas - are linked
to the underground economy, which can be loosely defined as that part of
the economy that goes unrecorded in official statistics and includes
activities which are concealed from the tax authorities in an attempt to
evade taxes. Many self-employed persons are involved in tax evasion and
underground economic activities because there is no formal system of
documentation for self-employed persons and their activities. The
Pakistan Institute for Development Economics (PIDE) reports (1998,
2003) show that the size of this economy has been growing faster than the
formal economy and estimate that it grew from about 20 per cent of the
gross domestic product (GDP) in 1973 to 54.5 per cent in 1998 but then
declined to 37.25 per cent by 2002. Estimates of tax evasion show similar
trends. The report ascribes the decline to changes in the overall economic
activity, smuggling, documentation of the economy, adoption of the antismuggling policy and so on. However, it must be remembered that these
estimates do not yield precise measures but only broad indications of
trends.
4. Size of the informal finance sector
The informal sector accounts for as much as a quarter of the GDP
in certain countries. In Pakistan, despite the substantial expansion of
formal credit institutions, the predominance of informal rural credit is
manifest from its reportedly high share in total credit extended to the rural
population in cash and/or in kind.
Clearly, institutional credit grew in Pakistan during the 1970s and
1980s. On an aggregate, the institutional sources which were responsible
for about 10 per cent of total borrowing for all cultivators combined in
1973 rose to account for nearly 40 per cent in 1985, mostly due to increased
lending by the Agriculture Development Bank of Pakistan (ADBP, now
5
Many selfemployed
persons are
involved in tax
evasion and
underground
economic
activities
because there is
no formal system
of
documentation
for self-employed
persons and
their activities.
the ZTBL). The importance of borrowing from friends and relatives
among non-institutional sources declined in this period while that of
commission agents and merchants remained about the same.
Table 1: Percentage Distribution of Total Borrowing by Source
Sources
Institutional
sources
Non-institutional
sources
Total
1973
9.8
1985a
39.5
1985b
58.5
1990
23.6
1996
22
90.2
60.5
41.2
76.4
78
100
100
100
100
100
Source: Malik (1989); Malik (1991)
With credit
requirements but
few assets that
can serve as
collateral, the
poor are thus
shut out of
formal finance
markets.
A comparison of the share of informal rural credit in Asian
countries shows that this share is high in all countries, especially Pakistan.
The share along with the reporting year is: Philippines, 71 per cent (1978);
India, 70 per cent (1972); Bangladesh, 63 per cent (1974); Pakistan, 73 per
cent (1985); Malaysia, 62 per cent (1986); Thailand, 52 per cent (1985);
Indonesia, 52 per cent (1985); South Korea, 50 per cent (1981) (World
Bank, 1996).
5. Implications of IFMs for poverty
The lack of well-functioning financial markets has
disproportionately adverse consequences for the poor: with credit
requirements but few assets that can serve as collateral, they are shut out of
formal finance markets. As a result, the poor have strictly limited
possibilities for consumption smoothing in response to income and other
risks, for financing production enterprises and longer investments through
saving, lending and insurance. Worse still, the severe asset inequalities and
lack of well-functioning financial markets in Pakistan are not offset by
access to financial services which in turn forces the already dependent
people to search for security within the 'moral economy' through the
system of patronage and patriarchy. Poverty is thus perpetuated by further
narrowing the ability of the poor to exploit economic opportunities.
6
A Study of Informal Finance Markets in Pakistan
All the available evidence from Pakistan suggests that richer rural
households have better access to cheaper institutional credit whereas
poorer households depend mainly on expensive informal or noninstitutional sources. This is in line with international empirical evidence
which shows that richer people borrow more and pay lower rates of
interest and that bigger loans are associated with lower rates of interest.
The National Human Development Report (NHDR, 2003)
shows that people below the poverty line tend to increase consumption by
taking loans and selling their assets. But since their access to credit is
limited and they have few assets, they suffer from extreme nutritional
deficiencies and rely on transfers to supplement their incomes.
Furthermore, the NHDR data also shows that the indigent have very high
ratios of loan dependence on landlords and this dependence declines
proportionately for the poor and the non-poor. Absolute levels of
indebtedness show a similar pattern but are generally far higher in the rural
areas compared to urban areas when measured as a percentage of income.
Indeed, this high rate of indebtedness is a major hurdle in povertyalleviation programmes based on credit alone. The NHDR data shows that
most loans in both urban and rural areas are taken for meeting
consumption needs. Since institutional creditors do not officially provide
loans for consumption purposes, the report reveals that friends and
relatives are the major lenders. The Survey of Informal Lenders (1996),
however, states that approximately 90 per cent of the total credit disbursed
by lenders was given for production and investment purposes and that only
shopkeepers, landlords and moneylenders extended some loans for daily
consumption. But since information on the purpose of the loan was
provided by lenders, it is possible that the ultimate use of the credit was not
known for certain.
Other surveys show that although farmers are generally able to get
informal loans in times of need, such lending is available only for certain
uses (for example, small consumption loans from friends and relatives) and
not for long-term productive investments (for example, land
improvement, land purchase or land leasing). In rural areas, this is
illustrated by data indicating a paucity of fixed-rent leases, which require
7
This high rate of
indebtedness is a
major hurdle in
povertyalleviation
programmes
based on credit
alone.
upfront rent payment. In an environment where over a third of all
cultivated area is leased out, this is particularly significant, and suggests that
the informal credit market is by no means adequate and bears adverse
productivity implications for poor and landless farmers. The low/no
interest loans from friends and relatives are obtained largely by better-off
households. Marginal and small owners and landless tenants have the bulk
of their credit needs met by lenders other than friends and relatives.
6. History of informal finance
The indebtedness to informal lenders in the rural areas is not a
new phenomenon. Thorburn (1886) vividly depicted the dominance of
moneylenders in the Punjab. Darling (1925) reported high levels of
indebtedness from surveys of Punjabi proprietors and found that debt was
more widespread and deeper in the Punjab than in the rest of India. He
discovered that there were 40,000 moneylenders in the province, over 80
per cent of Punjabi proprietors were in debt and the average debt per
indebted proprietor was equal to about three years of his net income.
According to his estimates, a large part of the debt was unproductive,
being either compound interest or spent on extravagant expenditures such
as marriages and that “only the smallest fraction, almost certainly less than
5 per cent, is due to land improvement.”
With the advent
of British rule,
the power of
moneylenders
increased
significantly.
Moneylenders have been an integral part of the rural economy
since ancient times and have historically played a vital role in smoothing
consumption and financing village transactions. But with the advent of
British rule, the power of moneylenders increased significantly due to a
decline of the earlier vigorous village communities, replacement of
communal ownership of land with individual rights and the establishment
of civil courts which facilitated contract enforcement. Moneylenders
further consolidated their growing power by resorting to widespread
malpractices in maintenance of accounts.
The moneylender ensured repayment primarily through social
sanction and failing that, through civil court decrees. The instrument of
mortgage, which became widespread during the early period of British
rule, resulted in massive land transfer from the landowners to the
8
A Study of Informal Finance Markets in Pakistan
moneylenders. Out of 742 families examined during an enquiry by
Thorburn in 1896, “only in 13 cases did a once involved man recover his
freedom.” Thorburn reports that similar conditions prevailed in the
NWFP and Sindh where the big landlords were all deeply encumbered in
debt. Such conditions prompted the British government to intervene with
the 'free' operation of IFMs in pursuance of its political objectives. The
British sought to protect the interests of its loyalist agricultural owners/
indebted landlords through the Sindh Encumbered Estates Act 1876, and
the Punjab Alienation of Lands Act 1900, which prohibited the purchase
and alienation of lands from 'agricultural castes' and thus reduced the
threats to mortgaged lands. Similarly, during the depression of the 1930s
the British protected several large estates (landholdings) from a change in
ownership due to heavy indebtedness and insolvency owing to the
downturn in agricultural prices and rents. In the Punjab, for instance,
protection was sanctioned through The Punjab Relief from Indebtedness
Act 1934.
Presently, the moneylending business is legally covered under The
Punjab Moneylenders Ordinance 1960 under licence from a collector who
can also cancel it in case of forgery, fraud, conviction or excessive interest.
But this ordinance is practically redundant and no records are currently
maintained by the revenue authorities. Some people believe, however, that
its repeal will lead to a decrease in the actual incidence of moneylending.
Recently, a private bill introduced in the Punjab Assembly seeks to ban all
private moneylending.
7. Providers of informal finance
There are a large number of informal finance markets and each
generally operate singly without the links that characterise well-integrated
financial markets. The multiplicity of IFMs is reflected in the observed
diversity of transactions in these markets: lending and borrowing among
close relations, rotating saving and credit associations (RoSCAs),
moneylending, interlinked financing, suppliers' credit and so on.
Lending and borrowing among relatives, neighbours, friends and
other socially close lenders is very common for financing needs, especially
9
The
moneylending
business is
legally covered
under The
Punjab
Moneylenders
Ordinance 1960.
But this
ordinance is
practically
redundant and
no records are
currently
maintained by
the revenue
authorities.
for consumption-smoothing purposes. Such transactions have the
advantage of being collateral-free and, in most cases, free of interest as
well. These transactions rely on the principle of reciprocity and represent
informal social insurance schemes; both the lender and the borrower gain
from the transaction and the process becomes self-sustaining. The
borrower is able to finance urgently needed expenditures quickly and with
little transaction costs since there is no lengthy appraisal process involved,
little or no paperwork or travel time and the terms of transactions are well
understood. A study of the informal sector's role in the NWFP (Integrated
Development and Entrepeneurship Advisory Services [IDEAS] 1999)
found the greatest volume of financing came mostly from friends and
relatives. The study found that there is no additional cost or interest when
borrowing from relatives and friends except in some cases where a profitsharing arrangement has been made. Shopkeepers are another important
source of lending, especially in rural areas and among low-income
households.
While moneylending is still a big source of funds for those
rationed from formal finance markets, most moneylenders actually have a
different principal economic activity. This diversification helps them cope
better with the risk and uncertainty in their incomes. Interlinked
contracting, another common mode of informal financial arrangements,
usually takes the form of tied credit where the supply of credit in the form
of cash or input supplies is linked to the purchase of the produced output
at a highly discounted price. Moneylending and interlinked finance are
discussed in detail later.
In a rotating saving and credit association (RoSCA) or committee,
as it is commonly known, a group of participants puts contributions into a
pot that is given to a single member and this process is repeated over time
until each member has had a turn, with order determined by list, lottery or
auction. The member gains demand deposits, once the saving is
committed, but it cannot be drawn immediately and the member is
required to wait his/her turn. The main goal of a RoSCA is to mobilise
savings and channel them to borrowers in some pre-specified order, thus
fulfilling an important intermediation function. In RoSCAs, individuals
While
moneylending is
still a big source
of funds for those
rationed from
formal finance
markets, most
moneylenders
actually have a
different
principal
economic
activity.
10
A Study of Informal Finance Markets in Pakistan
pool their savings on a regular basis to generate loanable funds primarily
for its members. Not only are the organisational and monitoring costs very
low, default rates by the very nature of RoSCAs are low as well.
RoSCAs exist in almost all developing societies and in some
developed countries as well under different names and have very long lives.
But the essential features of RoSCAs, in terms of a revolving fund for
financing lump-sum expenditure, are similar. Generally, it usually involves
a group of people coming together and contributing a fixed sum of money
after every specified time period. This pot is then allocated to one of the
members of the group. This process continues till every member has
received the pot. After that the group can disband or start again. There are
a number of ways of allocating the pot (random selection, pre-set order or
auctions) and a number of ways of setting up the group, selecting members
and enforcing discipline. Some RoSCAs even have discounts built into
them to take care of costs for later recipients. But the essential features of
the revolving fund carry across all RoSCAs.
For any relationship where payment is made now and repayment
is made over time, the possibility of default is always present. Banks avoid
this through collateral, but committees do not require physical capital as
collateral. RoSCAs work in societies and groups that have strong
reciprocity relationships which allows for the selection of trustworthy
members and the avoidance of default. Moreover, ostracisation in its
various forms acts as a sufficient deterrent. If a society has a very efficient,
complete and well-structured financial system, RoSCAs would not be
needed. Banks and other formal sector institutions would then be able to,
in theory, serve all who were willing and able to pay the requisite financial
costs. But the financial system is not complete, has large asymmetries of
information and rations a significant proportion of the population. Under
these circumstances, RoSCAs present one way for these populations to
provide for themselves by allowing people to save and access funds for
those buying large consumer items and sometimes for financing working
capital or project finance requirements.
From housewives to businessmen and among the lower and lower
11
RoSCAs work in
societies and
groups that have
strong
reciprocity
relationships
which allow the
selection of
trustworthy
members and
the avoidance of
default.
middle classes, RoSCAs are a widely used institution in Pakistan for
financing capital expenditures. It is an institution that 'forces' people to
save. “It performs a dual purpose of credit as well as saving. For early
receivers, it is a credit, i.e., if one has contributed 100 Rs. and has received
1,200 Rs. which he is supposed to repay in interest-free instalments of 100
Rs. per month. For late receivers, however, it is a saving which somehow or
other comes into the category of compulsory saving … The method lacks
any intervention of the formal credit and saving institutions. A small saver
does not have to hide the cash at home or to deposit it with some relative
for safety. Another advantage may be the availability of the interest-free
credit for the early receiver, which is hardly available in any other method.
The receivers may also exchange their turns through mutual consent if
someone needs the money immediately,” (Waheed, 1996).
Auction RoSCAs, on the other hand, involve fairly complex
dynamic auctions and the bidding system outcome is often lending at a
market-determined interest rate. As a part of this study, several auctionbased committees were observed in different markets. One of these was an
auction-based committee of 125,000 rupees with 125 members each
contributing 1,000 per month. In the month observed, the committee was
auctioned for 61,500 rupees leaving a saving of 63,500 rupees. This saving
was added to the savings from the previous month, which equalled 32,500
rupees, and then a second committee of 96,000 rupees was auctioned. This
second-round committee was bid for 63,000 rupees and the saved amount
of 33,000 rupees was carried forward to the next month. The process
continues till all members receive a committee. In some markets,
committees are only operated during the peak season.
In a survey conducted for this study in the urban markets of
Lahore, RoSCAs were a fairly common phenomenon. (However,
committees as a means of financing business were found to be
unsuccessful in some markets due to high default rates caused by weak
contract enforcement once defaulters began using court injunctions or
stay orders to stop paying.) Similar findings were observed in other markets
in Peshawar, Karachi and elsewhere and some markets still have auctionbased committees. Most of the respondents reported that women from
Auction
RoSCAs, on the
other hand,
involve fairly
complex
dynamic
auctions and the
bidding system
outcome is often
lending at a
marketdetermined
interest rate.
12
A Study of Informal Finance Markets in Pakistan
their households were also participating in RoSCAs for household needs,
although these involved much smaller amounts.
8. Urban finance
The informal sector refers to economic activities that are
organised outside the penumbra of the state's judicial and administrative
machinery. In the absence of state-provided institutional infrastructure,
agents in the informal markets often devise or adapt institutional
mechanisms to reduce their costs of transacting. It generally includes a vast
and heterogeneous array of small-scale, family-based, unregistered, petty
trades and casual labour activities that are marked by relative ease of entry,
flexible structure and hours of operation, simple and relatively labourintensive technologies, and low formal skills.
Often regarded as a kind of fallback, the informal sector acts as a
cushion or a social safety net that provides employment to those unable to
get jobs in the formal sector. Another view stresses its positive role in
providing employment and incomes as well as its potential role as a source
of productivity leading to economic development. There is wide
agreement that SMEs play a vital role in the structural transformation from
low to middle income levels and in providing employment and output in
the early and middle stages of the transformation. But this does not appear
to be the case in Pakistan. “In Pakistan the SME sector has acted neither as
a significant engine of growth, nor as an important conduit for structural
change. Judging from international experience, Pakistan might represent a
case where the potential of SMEs has not been adequately exploited”
(World Bank, 2003).
Owing to mass urbanisation - especially the proliferation of periurban areas and development of major urban systems - and the inability of
the formal sector to cater to the needs for settlements, employment and
service delivery, the informal sector seems to have mushroomed in
Pakistan in recent decades. Nonetheless, various studies indicate that its
growth is seriously constrained by low access to capital which is
exacerbated by its non-legal and unregulated status, lack of authorised
business locations, collateral requirements and perceived risk of operation.
13
Often regarded
as a kind of
fallback, the
informal sector
acts as a cushion
or a social safety
net that
provides
employment to
those unable to
get jobs in the
formal sector.
Indeed, a majority of establishments in the non-agricultural sector are
micro-enterprises. In the Punjab alone, the private sector provides close to
nine-tenths of total employment while an overwhelming share of private
sector employees work in units with less than 10 employees. Thus the
livelihood of the majority of the population depends overwhelmingly on
the small enterprises, particularly in the informal sector. This highlights the
fact that poverty reduction is closely linked to improving productivity.
Urban financial markets are different from rural ones in certain
important respects. The former are characterised by closer proximity and
greater mobility of the participants which has implications for information
flows and socio-economic dynamics. Players in urban markets also tend to
be wealthier, resulting in a greater ability to bear risks and to offer tangible
collateral. The rural and urban financial markets are also marked by an
asymmetry: a borrower and lender in an urban market today may be in the
reverse situation tomorrow but, in rural IFMs, lenders and borrowers have
generally distinct identities and the same individual is the principal or agent
in all repeated transactions. The nature of power relations among the
respective participants is also different in rural and urban IFMs. Many
urban markets catering to traders, especially wholesalers, have a long
history and are quite well developed in terms of the amounts of funds
intermediated, the speed and efficiency of the intermediation, and the
sophistication of participants as well as the market as a whole. The larger
of these markets also set interest rates and the terms of transactions which
are then followed by the smaller and relatively less-developed markets.
In the Punjab
alone, the
private sector
provides close to
nine-tenths of
total
employment
while an
overwhelming
share of private
sector employees
work in units
with less than 10
employees.
A common feature of all urban markets is suppliers' credit, with as
much as 90 per cent of transactions in old markets with established players.
Its prevalance is attributed to liquidity constraints and the avoidance of
handling cash and tax documentation. There is generally a two to four per
cent discount built in for cash payments. Richer parties often have the
advantage - a symptom of class segmentation - because they are able to get
better prices on cash as well as better deals even on supplier' credit.
Meanwhile, immediate financing was also found to be available in urban
IFMs through moneylenders on personal guarantees.
14
A Study of Informal Finance Markets in Pakistan
In many markets, a chit or parchi is the norm for making business
transactions and is seldom dishonoured. This system represents a
convenient and flexible method that allows business to be conducted at
doorsteps without the hassle of documentation or tax liabilities. It was
found that most businessmen maintained their accounts through chits,
partly due to the lack of skills for maintaining a modern accounting system
but also because of a fear of tax authorities. Most shopkeepers privately
admitted that tax evasion is a common phenomenon which is why a large
number of businessmen maintain double accounts: there is a margin
between cash and credit sale which varies from party to party as well as
duration.
The role of market associations, according to most respondents,
was very crucial. These associations not only help mediate disputes
through moral persuasion and social pressure or boycott but create a
congenial atmosphere in which to conduct business through collective
action - a significant function since honour and personal guarantees rather
than written contracts are the custom. In a study of Delhi's urban markets,
Srivastava (1990) reports: “participants in these markets often have access
to diverse institutions, such as market-wide organized associations that can
create, maintain, and enforce complex contractual mechanisms that lower
costs of transacting for individuals.” A general rule followed by many
market associations is that when a defaulter approaches any shop for a
business transaction (generally to sell his product), the shopkeeper is
obligated to pay the defaulted party. The respondents also felt that in
markets where associations are not as strong, there tended to be far more
instances of fraud either through reneging on contracts or by supplying
low-quality goods.
Transactions in wholesale markets are facilitated by the fact that
many traders have had their business handed down to them through the
generations and they thus have links across the markets as well as the
country. In most of these markets, the risks associated with arms-length
transactions have been countered through institutional innovations and
human contact and trust. The fact that such markets are dominated by
certain business families such as the Sheikhs helps build trust (signalling
15
The nature of
power relations
among the
respective
participants is
also different in
rural and urban
IFMs.
effect) through informational advantages from social flows and personal
relations. Most respondents said that they interact with their business
partners socially as well and they would trust a partner more if he were
from the same community or if they had greater interaction with him.
Although such social interaction helps gather information needed for
conducting business transactions, it also acts as a barrier to the entry of
new players.
In certain IFMs, there are fairly well-functioning forward markets
that link input suppliers, manufacturers and wholesale traders. The
shoemaking industry was observed in different cities and different markets
in Charsadda, Lahore, and Karachi. In the shoe market of Shah Alami,
Lahore, for instance, small manufacturers who supply shoes to the
wholesalers get IOUs which can be redeemed after one month. Since these
manufacturers need working capital to purchase inputs but their liquidity
constraint means that they cannot wait for a month to be repaid, they
approach a secondary market in Shah Alami to redeem the IOU for cash at
a discount of 10 per cent. Thus an IOU pledging a payment of 10,000
rupees is redeemed for 9,000 rupees in the same market. Similar practices
were also observed in Karachi.
In markets with a large number of new players, however, business
is largely conducted in cash since the default rate is very high and sale on
credit is only done with trustworthy parties. This makes it difficult for
newcomers to break in and acts as a barrier to entry. Most of the
shopkeepers involved in the wholesale and retail business were members
of RoSCAs while the small, informal producers were mostly engaged in
seasonal RoSCAs. When interviewed, all the small informal producers
responded that access to credit at market rates would help them make more
profit and expand their business since it would enable them to purchase
inputs on cash at better prices and to run their production cycle more
efficiently.
In markets with
a large number
of new players,
however,
business is
largely
conducted in
cash since the
default rate is
very high.
Meanwhile, the textile business is facilitated by the presence of
brokers and investors at every stage - from cultivation to processing,
manufacturing and finishing. These brokers mainly act as a liaison between
16
A Study of Informal Finance Markets in Pakistan
the concerned parties and charge a commission. In terms of enforcement
of contracts, in Faisalabad for example, the broker receives a slip from the
weaver and pays the spinner. This slip is equivalent to any cheque or bank
draft. This 'trust' has developed because of repeat transactions since
everyone knows everyone and no one can participate without a reference.
Everyone also knows the scale on which the concerned parties are working
and their reputation in the market. Firms have to make their payments on
time because if they do not, no one would be willing to work with them and
they would soon be coldshouldered. A mapping of IFMs in the textile
sector was carried out by the Punjab Economic Research Institute (PERI)
for this study.
In the transport business as well, informal finance markets are
quite common. In some urban areas, moneylenders mostly provide credit
in the shape of goods - in this case vehicles - to clients. The registration of
the vehicle remains in the name of the lender until the client pays the entire
amount with interest. Lending through vehicles is popular due to the ease
of impounding in case of default. The annual interest rate for credit in the
shape of goods varies on the financial position of the borrower and his
previous track record. The most widespread value of monthly instalments
is 5,000 rupees per month for every 100,000 rupees.
Interviews with three major financiers hailing from the tribal areas
of the NWFP in the transport business revealed that they considered
lending on interest to be un-Islamic, but regarded commodity and
transport financing as legitimate. According to them, more than 90 per
cent of commercial vehicles (mostly trucks) were operating on the
instalment system with repayment durations averaging between five and
eight years and with a gross mark-up over total financing (current price
minus down payment) ranging from 50 per cent to 100 per cent, depending
on the level and number of instalments. A second-hand truck costing 1.6
million rupees, for example, was observed to be sold with a 200,000-rupee
down payment for 2.4 million rupees (carrying a gross mark-up of one
million rupees) with instalments mutually agreed at 40,000 rupees per
month. Normally, since the lenders are more concerned with cash flows,
the interest rate does not explicitly enter the contract. Interest is instead
17
Interviews with
three major
financiers
hailing from the
tribal areas of
the NWFP in
the transport
business
revealed that
they considered
lending on
interest to be unIslamic, but
regarded
commodity and
transport
financing as
legitimate.
implied in the contract, which only shows the actual cost of vehicle, the
profit margin of the lender and the number of instalments. Thus a loan of
one million rupees in the shape of a vehicle may carry an interest rate of 20
per cent if the repayment period is one year and 30 per cent if it is two
years.
Default rates in transport financing were said to be very low. In
their personal experience, the respondents said that they had witnessed
only eight to 10 cases of default out of hundreds of transactions. In case
the borrower-owner wants to sell the vehicle, he usually introduces a
prospective buyer to the financier. The prospective buyer then arranges a
guarantor to the satisfaction of the financier and a deal is struck between all
the parties on the outstanding transactions. Similar financing patterns were
observed in the tyre business where the turnovers are much faster although
the margins are lower. The financiers largely hail from the NWFP or the
tribal areas and the borrowers are also mostly from the same community.
The social linkages thus help overcome screening and monitoring
problems, reduce the risk of default and ensure availability of multiple
channels in case of repayment problems.
Transport financing on instalments is also available at many places
in Lahore. Some financiers now resort to insuring vehicles while many
drivers who worked earlier on a daily-wage basis now get their own
vehicles. However, while the easy availability of vehicle financing and
leasing has mostly ended informal lending in new cars, it is still done for
second-hand vehicles. The terms of agreement differ with each party. In
each market, brokers act as middlemen who also offer a commission to the
potential borrower/buyer if he is acting as the agent of another party (a
case of principal-agent divergence of interests). The higher the instalment
the lower the interest charged: if the instalment goes up to 8,000 rupees,
for instance, the interest charged goes down to 20 per cent. Needless to say
that a client with a good past history is offered better terms. A default of
two or three instalments means that the vehicle is seized and then either a
revised contract is worked out with the old owner or it is sold and the new
purchaser and the old owners then share the loan.
The Survey of
Informal
Lenders (1996)
found that
except landlords
and
shopkeepers,
most informal
lenders were
concentrated in
towns which
they used as
bases to extend
their operations
to surrounding
villages.
18
A Study of Informal Finance Markets in Pakistan
In the dairy and livestock sector, traders advance credit to the
buffalo owners and in turn exercise a right to the produce from the animals
and charge a commission over it. In case of default, the issue is adjudicated
by a panchayat. In Karachi, for example, a group of six buffaloes costing
180,000 rupees was sold for 250,000 rupees on instalments to be repaid
within six months. The extensive prevalence of urban informal lending
was confirmed by the Survey of Informal Lenders (1996) which found that
except landlords and shopkeepers, most informal lenders were
concentrated in towns which they used as bases to extend their operations
to surrounding villages. It reported that on average, the business of
commission agents was spread over 19 villages, while that of
moneylenders and landlords over two villages each.
9. Informal savings
While savings are needed by all households for smoothing income
and consumption flows, they are especially vital for the poor. Being
excluded from the formal credit markets, they need savings to mitigate risk
and make productive investments in their farms or informal enterprises.
The poor save in a variety of financial and non-financial forms: farmers
save at harvest time to get through the pre-harvest lean season. Similarly
entrepreneurs with businesses that have high and low seasons save for the
low seasons during the high seasons. Many of the poverty-stricken count
everything except basic necessities as excess liquidity in order to save for
emergencies, investment opportunities, social and religious obligations,
children's education, and other purposes. The primary need of lowincome savers is to swap small savings flows for lump sums needed for a
variety of purposes (Rutherford, 2000). Entrepreneurs also save in the
form of raw materials needed for enterprise, finished goods, by stockpiling
construction materials, other liquid assets, or by saving in cash, gold and
land.
The Committee on Rural Finance (2003) suggests that savings in
Pakistan - although small because of a low national savings rate compared
with countries at a similar stage of development - are available in the rural
areas but are not being tapped due to the lack of institutional channels such
as banks for savings in the rural areas. It reported that rural areas contribute
19
Many of the
poverty-stricken
count everything
except basic
necessities as
excess liquidity
in order to save .
about 20 per cent of total bank deposits, but these are largely used for
lending in urban areas. As a result, people in rural areas invest their savings
largely in livestock.
Livestock can be bought and sold when needed and is a good
livelihood diversification strategy for low-income households. It helps
supplement their income through sale of milk and milk products and their
consumption as a food supplement as well as reduces their dependence on
a seasonal income through the harvest yields of crop products. Livestock
keeping also acts as an insurance against unanticipated events and social
ceremonies. The International Food Programme Research Institute
(IFPRI) Rural Survey of Pakistan (1986/87 to 1988/89) shows a strong
and positive correlation between ownership of buffaloes and household
income. Goats and sheep are another form of saving that is more popular
with women. Livestock is also kept through share leasing, a saving
arrangement between landlords and the professional strata or kammis.
However saving through livestock is vulnerable to a number of
uncertainties and hazards.
Another
traditional
saving
arrangement is
the reciprocal
exchange of
cash, kind and
favours called
vartan bhanji in
the Punjab.
Another traditional saving arrangement is the reciprocal exchange
of cash, kind and favours called vartan bhanji in the Punjab. This is an
account of cash and kind in a household that has been deposited by
another family to help them on certain occasions and is later withdrawn on
similar occasions from the depositor's household. Another such
arrangement in rural Punjab is called wanghar, which means asking others
for help on a voluntary and reciprocal basis. Here, a household helps
another household in need of excess labour: wanghar is normally arranged
for seasonal activities requiring extra hands such as sowing, harvesting,
threshing, building sheds or deras and so on. Hoarding gold and silver is
also common in rural and semi-urban areas. Mothers start saving small
amounts of jewellery for the marriage of their children, especially
daughters. Traditionally such jewellery is supposed to be retained for a
lifetime and transferred to the children, to be utilised only as a last resort
through sale or mortgage. Lately migrant workers from the Middle East
have also been bringing home stamped pieces of gold - to be sold in case of
need - and hence performing a saving function.
20
A Study of Informal Finance Markets in Pakistan
10. Informal transfers
Informal transfers are an exchange between households of cash,
food, clothing, loans and other informal assistance. Such transfers help
smooth the consumption of receiving households. These also impact
publicly funded social protection programmes through a private
compensatory response to public interventions. Empirical evidence
suggests that the bulk of informal transfers flow from older to younger
households, poor and vulnerable households are more likely to receive
private transfers while non-poor households are more likely to give private
transfers and female-headed households appear to be more likely to receive
them. While informal transfers do indeed help the poor in risk
management, they are not adequate substitutes for public action in social
protection. Public intervention is also needed when income shocks are
covariant, delivery mechanisms are costly, the severity of the income shock
is extraordinary and when shocks are repeated.
A popular informal system of transferring money around the
world is hawala1. It originated in the middle ages for financing trade but is
currently popular among migrants from Pakistan and other South Asian
countries as a speedy mechanism for sending remittances back home while
bypassing banks. It has some advantages over formal banking operations
since it is marked by low commissions, fast transactions, little
documentation with no identification required and round-the-clock
operation. The system works through individual brokers or operators
collecting funds at one end of the payment chain and others distributing
the funds at the opposite end. For example, an expatriate working in USA,
Europe or the Middle East, who wants to send money back to his family in
Pakistan, gives the money to a moneylender or trader with contacts in both
countries. The trader calls a trusted partner in the home country who
delivers the amount to the family, minus a commission. For identification
and the details of the trade, a code is often used. The two traders settle
accounts either through reciprocal remittances, trade invoice
manipulations, gold and precious gem smuggling, the conventional
banking system, physical movement of currency, or by reverse hawala.
Hawala markets are characterised by strong market segmentation.
21
Hawala markets
are marked by
low
commissions,
fast transactions,
little
documentation
with no
identification
required and
round-the-clock
operation.
Thus it has been observed that ethnic communities generally trust and deal
only with hawaladars who belong to their biraderi or community. While it is
illegal in many countries, even central or commercial banks make use of
the system. Anecdotal evidence suggested that most moneychangers
currently operate through Dubai. Usually, hawaladars operate
independently of each other rather than as part of a larger organisation
and are generally merchants or small business owners who operate hawala
activities alongside their normal business.
However, what makes the system attractive to expatriates and
migrant workers also makes it equally compelling for drug traffickers and
terrorists. A report estimates that 3,000 international hawaladars operate in
Asia with an estimated annual volume of 200 billion US dollars (Beate
Reszat, 2002). The hawala system has gained prominence following the
9/11 attacks in the US as a major medium for money-laundering, financial
crimes and financing of criminal and terrorist organisations. Pakistan has
taken a number of steps to check this practice, including Prudential
Regulations XI and XII to prevent the criminal use of banking channels
for the purpose of money-laundering and so on; the Control of Narcotics
Substances Act 1997 with special attention to unusual transactions, illicit
narcotics activities and a penalty for failure to report; and the National
Accountability Law, section 20, which requires banks to report unusual or
large transactions.
11. Rural finance
In rural areas, despite the expansion of institutional and policydirected credit, informal markets still supply most of the credit needed by
the low-income segment of society. A high concentration of the banking
sector in urban areas, especially big cities, and its primary focus on
servicing urban and industrial needs leaves limited financial channels
available to the rural poor and small farmers who then resort to informal
means of savings and credit. Such credit is mostly supplied by aartis or
commission agents and other middlemen at high interest rates through
interlinked transactions. The acute shortage of capital at affordable rates
severely inhibits the growth of the rural economy. Moreover the lack of
appropriate saving and insurance products in rural areas prevents efficient
However, what
makes the
system attractive
to expatriates
and migrant
workers also
makes it equally
compelling for
drug traffickers
and terrorists.
22
A Study of Informal Finance Markets in Pakistan
resource mobilisation and risk management.
Rural finance encompasses credit, savings, insurance and payment
services. Credit is needed for agriculture, rural business and agriculturerelated activities including retailing-wholesale activity, rural enterprises,
and for marketing rural produce. Payment services are important in rural
areas due to the geographical dispersion of economic agents and are
needed for the transfer of remittances and payment of funds. The rural
credit market includes primary processors such as ginners, rice shellers,
those working in flour mills and so on who are financed substantially by
commercial banks. It also includes agriculture service providers such as
aartis, agriculture input dealers and shopkeepers who are very sparsely
serviced by institutional finance and depend primarily on their own cash
capital. The non-poor and better-off farmers are being serviced by the
likes of the Zarai Taraqiati Bank Limited (ZTBL), commercial banks and
co-operative banks. Finally it includes the poor, landless or small
landholding farmers, who do not possess the necessary collateral to access
institutional credit. Their financial needs are mostly serviced by informal
lending at rapacious interest rates and in some areas by a few NGOs or
microfinance institutions providing collateral-free microfinance.
The formal credit market includes taccavi loans, commercial banks
(especially active since 1972 when they were given mandatory agricultural
credit targets), co-operative societies and the ZTBL. However, lending
from co-operative societies is no longer a major phenomenon. The cooperative banking sector was sustained by an enormous subsidy from the
State Bank of Pakistan (SBP) from 1985 to 2001 but the system became
mired in inefficiency, corruption and outright fraud. This was amply
demonstrated in two studies conducted by PERI in 1986 and 1997: for
instance, the 1986 study found that out of the sample survey only four per
cent were genuine co-operative societies, 22 per cent totally bogus
societies, 39 per cent one-family-owned societies and 35 per cent one-man
societies. The 1997 study showed similar results, finding only 3.9 per cent
genuine societies in the Punjab sample and only one-man societies in the
Azad Jammu and Kashmir (AJK) sample. The PERI 1986 report showed
35 per cent proxy and fictitious loans out of the sample loans. Out of the
23
Such credit is
mostly supplied
by aartis or
commission
agents and other
middlemen at
high interest
rates through
interlinked
transactions.
remaining 'loans actually got' (i.e. 65 per cent), 23 per cent were genuine
loans, 22 per cent with area over reported and 20 per cent with area under
reported. Furthermore, the report found that the main beneficiaries of
proxy loans were landlords who got 77 per cent of the loans.
Unfortunately, institutional credit is largely serving the privileged
and better-off farmers. This includes commercial banks that have
ventured into the agriculture credit sector only reluctantly and are primarily
dealing with a small number of better-off farmers, as well as co-operative
banks that have played an even smaller role. In fact, institutional credit
represents a classic case of the elitist capture of subsidies targeting poor
farmers. The huge SBP subsidy to the co-operatives resulted in an even
greater monopolisation of agriculture co-operative credit by influential
farmers. The credit market in Pakistan is highly concentrated and seems to
exist primarily to service urban and industrial needs. According to the
Committee on Rural Finance (CRF), about 80 per cent of total advances
are concentrated in just seven cities.
Institutional
credit represents
a classic case of
the elitist
capture of
subsidies
targeting poor
farmers.
A CRF (2003) report found that only 5.6 per cent of total
advances - about 21.5 million rupees in 2000 - are made from the rural
branches of commercial banks. Commercial banks provide financial
intermediation services only to commodity processors and agriculture
service providers and even this segment is not adequately serviced. The
CRF (2003) argues that the neglect of the rural finance market by
commercial banks is best shown by their lack of interest in pursuing the
agriculture aarti or wholesalers market. The number of clients of all
commercial banks, ZTBL and co-operative banks came to 720,000 in
1999-2000. But these figures overstate the number of borrowers since
these include loaning for two-crop cycles - rabi and kharif - resulting in
double counting. The Committee on Rural Finance estimated that the
number of farmers availing all types of agricultural credit from all banks in
the country can be safely assumed to be no more than 577,000. This figure
shows that only 15 per cent farmers are availing institutional agricultural
2
credit . This is exactly half of the coverage shown by the traditional
measure of the volume of credit. The CRF estimates, however, that even
this figure is inflated due to the widespread practice of borrowing from
24
A Study of Informal Finance Markets in Pakistan
institutional sources in the name of their haris, servants and families by
large and influential farmers.
Suppliers' credit or credit from marketing agents is a major source
of rural lending. Its importance has increased since the Green Revolution
due to rapid commercialisation and intensified trading activity. For
instance, much of the marketed rice is procured by private marketing
agents consisting of paddy traders or commission agents, rice millers,
wholesalers and retailers. These agents usually engage in moneylending as a
means to acquire and to secure the trader's share in the output market. The
dominance of marketing-agent credit lies in the substantial advantage that
these agents possess in the access to information and in enforcing
repayment. Marketing-agent lenders provide loans to the vast majority of
small farmers, who are rationed by formal financial institutions under the
perception that they are risky, non-creditworthy prospects and, in the
process, are able to obtain very high repayment rates.
12. Characteristics of informal finance markets
Information constraints: The fundamental feature creating
imperfections in credit markets is the lack of information regarding the use
to which a loan will be put as well as the repayment decision. This
deficiency includes limited knowledge of the innate characteristics of the
borrower that may be relevant in such a decision and limited knowledge of
the defaulter's subsequent needs and activities, which place limits on his
incentive to default. All the important features of credit markets can be
understood as responses to these information problems. Unlike
commercial banks, informal lenders use personal, social and business
relationships to pre-select clients. RoSCAs use group membership as a
selection device, while traders and landlords only lend to their customers
and tenants. Moreover, recommendations from previous clients and
personal knowledge are important ingredients in the selection process.
Level and variation of interest rate charged: Informal markets are
generally characterised by high interest rates and a sizeable gap between
lending and deposit rates. Aleem (1990) reports that the average interest
25
Suppliers' credit
or credit from
marketing
agents is a major
source of rural
lending.
rate charged by moneylenders in Chambar was 78.5 per cent; in that year,
the bank rate in Pakistan was 10 per cent and the opportunity cost of
capital to these moneylenders worked out to 32.5 per cent. For
comparison, the “Summary Report on Informal Credit Markets in India”
(Dasgupta, 1989) finds results from a number of case studies in which the
average interest rate charged by professional moneylenders for the rural
sector is about 52 per cent. The IDEAS study in NWFP (1999) found the
interest charged by moneylenders ranged from 40 per cent to 120 per cent
per annum depending on the amount of money borrowed and time period
of repayment. The rate of interest for short-term financing in film
industry circles at Lakshmi Chowk, Lahore, reportedly ranges from 100 to
300 per cent. Because lenders in the informal market enjoy a sort of
monopoly position, they are thus able to charge exorbitant rates of
interest. In interlinked contracts, especially those of credit-labour, the
actual interest charged is considerable because of the implicit rate of
interest involved. There is extreme variability in the interest rate charged by
lenders for similar loan transactions.
Low levels of default: IFMs are generally marked by low levels of default.
Giving default rates for individual lenders, the study by Aleem found the
median default rate to be between 1.5 and two per cent and the maximum
10 per cent. According to the IDEAS study (1999), however, there is
virtually no default in the informal sector. In transport financing,
repayment is only delayed in extremely unavoidable circumstances such as
death of the client, accident of the vehicle purchased on credit and so on.
While this lowers the profit or interest earned, the amount is eventually
recovered from the client or his family. In case of cash lending, there have
been instances where the borrower could not pay due to bankruptcy and
the legal course to recover from the sale of mortgaged property may take a
long time. It is therefore not possible to recoup the whole principal amount
in such cases. The Survey of Informal Lenders (1996) also estimated the
ultimate default rate to be less than six per cent. It cited repeat transaction stemming from a desire to maintain the credit line - and social pressure as
the main reasons for high repayment rates.
According to the
IDEAS study
(1999), there is
virtually no
default in the
informal sector.
Some moneylenders were reportedly powerful enough to take
26
A Study of Informal Finance Markets in Pakistan
land from the borrowers in lieu of an unpaid loan. RoSCAs or committees
require no overhead and capital accumulation since all participants are
residents of the same area or are colleagues - mostly linked through more
than one channel - and default chances are checked by social pressure and
group sincerity. But considerable anecdotal evidence suggests that auction
RoSCAs with a large number of members went out of fashion because of
several defaults which forced traders to form smaller and simpler
committees that were either random-based or need-based. In urban
markets, social sanction, past history and repeat transaction help keep
default rates low. But it was observed that in markets where new players
constitute a large share, collective action through unions was not very
effective and there was anecdotal evidence of organised 'collection
brigades' and qabza groups.
Interlinkage: Interlinked transactions are defined as “contracts made
between the same pair of individuals relating exchange in more than one
commodity or service, the contracts being linked in an essential way so that
delinking the contracts would be infeasible or costly for at least one party.
So contracts between a pair of individuals in two or more commodities
that are linked by coincidence, i.e. contracts that could as well have taken
place without change at different points in time and not necessarily
between the same individuals, are not inter-linked in this sense.”
(Braverman and Srinivasan, 1980). Intertemporal linking or interlinkage of
present and future transactions is quite prevalent, especially in the labour
market.
Interlinked contracts are a response to screening, incentive and
enforcement problems. These problems arise when one party of an
economic transaction cannot observe the characteristics or actions of the
other party, cannot rule out default by compelling repayment once the loan
has been made, and when it is costly to determine the extent of the risk.
Such uncertainty may be faced by a landlord regarding the level of effort
that his tenant puts in, or about whether he will obtain sufficient labour
during peak agricultural season. Similar uncertainties may be faced by
commission agents regarding their share of the cultivators' crop. Such
situations provide incentives for these agents to link one transaction with
27
Interlinked
contracts are a
response to
screening,
incentive and
enforcement
problems.
another. Credit transactions are frequently tied with transactions in land
and labour markets. Thus, traders disburse credit to farmers in exchange
for the right to market the growing crop; shopkeepers increase sales by
providing credit for food, farm inputs and household necessities; large
landholders secure access to labour in the peak season in return for earlier
loan advances to labourers. An important feature of such transactions is
that the lender also deals with the borrower in a nonlending capacity and is able to use this position to screen applicants and
enforce contracts.
The extent of interlinkage in Pakistan is borne out by Mansuri's
study (1997) based on data from the Punjab and Sindh which shows that
among tenant households, landlords are the dominant source of credit.
But this relationship changes as we move to owners. For the class of
owner-cum-tenants, loan sources are almost equally balanced between
traders and landlords. Finally, those who are owner-cultivators receive their
loan funding largely from traders. “In the Punjab or the Sindh, virtually all
traders provide inputs on credit to cultivators. Traders do not require
collateral and don't charge interest, but most loans are interlinked with the
sale of agricultural output to the trader. In one type of contract, often
referred to as kachi bol, the trader specifies the amount of crop required as
loan repayment. Another type of contract, often referred to as kabala,
requires the sale of a specified amount of crop to the trader at a discount
below the announced support price or, in some cases, below the harvest
price. Finally, some loans are given simply against a promise that the farmer
will sell all of his crop to the trader at harvest at the going market price.
Because the market price of agricultural output tends to at its lowest level
just after harvest, the compulsion to sell at harvest introduces an element
of implicit interest in an interlinked contract,” (Ray 1998).
While the interlinking moneylender has an edge over other
moneylenders, there are some advantages for interlinked borrowers as
well. For the borrower who is shut out from institutional sources,
interlinked contracts are an attractive option as these ensure that he not
only gets the money without any formalities but also secures a job for
himself throughout the year by offering his labour services to a landlord or
While the
interlinking
moneylender has
an edge over
other
moneylenders,
there are some
advantages for
interlinked
borrowers as
well.
28
A Study of Informal Finance Markets in Pakistan
ensures a ready market for his crop, thus relieving him of the worry of
storage and of finding buyers for his output. But such contracts are also
highly exploitative and their exploitative aspects sometimes far exceed the
beneficial aspects.
Debt bondage and informal credit: One form of an exploitative
interlinkage between credit and labour markets exists through the system
of peshgi, or advance payment for workers, which often results in debt
bondage. This is usually disguised behind seemingly legitimate and
'voluntary' economic transactions where, in addition to the transaction in
the labour market, a worker also transacts with the employer on the credit
market and repays his debt by working for the creditor. The employercreditor enjoys monopolistic power vis-à-vis the worker-borrower, and is
able to impose exploitative terms and conditions in both transactions. The
worker is considered a bonded labourer if the terms faced on either or both
markets are extraordinarily exploitative and allow no exit from either or
both sets of contracts.
The peshgi system prevails in many informally organised sectors
where a worker-borrower contracts a cash or kind advance – in case of
agricultural tenants the advance is in the form of a production credit from
the employer-creditor. The worker-borrower then works on a piece-rate or
wage-rate basis and a part (in some cases all) of his earnings go to repay the
advance. The worker-borrower cannot change employers or locations as
long as the loan remains unpaid unless the new employer takes over the
loan, thereby becoming the creditor. The role of the peshgi system is crucial
in the understanding of bonded labour in Pakistan.
The system of peshgi is also very common in the carpet industry.
Field data gathered from all the four provinces in the Bonded Labor
Research Forum (BLRF) report, 2004, reveals that all workers have taken
loans/advances from their employers. These loans range from as little as
800 rupees to 75,000 rupees and are paid back in small instalments every
week. The workers are bound to work for the employer until the loan is
fully repaid. But because of the peshgi system, amounts sometimes
exceeding more than two years of earnings and with high interest rates,
29
The employercreditor enjoys
monopolistic
power vis-à-vis
the workerborrower, and is
able to impose
exploitative
terms and
conditions in
both
transactions.
workers are left with little to sustain their livelihoods. Debt bondage of
children against an advance payment for their labour is also common,
especially in Thar, Sindh.
One of the interesting innovations in the informal lending market
is a group-based lending contract where a producer makes an advance
payment to a worker on the guarantee of a group of six workers. If the
borrower leaves work without clearing his debt, the lender-employer
recovers his advance from the remaining six workers. This form of
employer-employee credit transaction was reported from some tanneries
in Kasur, Punjab.
As a coercive labour arrangement, the peshgi system is embedded
in the wider relations of dependence and power between unequal social
groups. But contrary to the popular view that peshgi legitimises bonded
labour, Gazdar and Khan (2004) argue that it may be one way in which
workers can secure advance payment for their services that may go
unremunerated if their accounts are settled only at the end of the contract
period. “In conditions where the general contractual environment is
insecure, workers who are socially weak compared to their employers are
likely to be fearful of employer default … The peshgi system, according to
this view, is not a credit arrangement designed to ensure labour supply.
Rather, it is an assurance device that allows workers to enter a contract in an
otherwise insecure contractual environment. Those workers who are
vulnerable to employer default are the socially weak, and therefore also
vulnerable to other forms of coercion and abuse. The key to ending
bonded labour according to this interpretation lies not in improving poor
people's access to credit, but in improving the overall contractual
environment and reducing social hierarchy.” Serious empirical work is
needed to explore whether the peshgi system, interlinking labour and credit,
is a control device over workers or an assurance device for workers.
As a coercive
labour
arrangement,
the peshgi
system is
embedded in the
wider relations
of dependence
and power
between
unequal social
groups.
Rationing: Informal credit markets are marked by widespread rationing,
that is, there are upper limits on how much a borrower receives from a
lender. This implies that, at the going interest rate, the borrower would like
to borrow more but cannot. Rationing comprises the complete exclusion
30
A Study of Informal Finance Markets in Pakistan
of some potential borrowers from credit transactions with some lenders:
at the going terms offered, certain borrowers would like to borrow but the
lender does not lend to them. In this sense, rationing is closely connected
to the notion of segmentation. Such markets are also characterised by
layering where the principal moneylender sub-lends to other
moneylenders, each of whom maintain tight circles of trusted clients
outside which they are unwilling to lend.
Segmentation and exclusivity: Segmentation is another feature of
informal credit markets. Many credit relationships are personalised and
take time to establish. Typically, a moneylender serves a fixed clientele,
whose members he lends to on a repeated basis and he is extremely
reluctant to lend outside this circle. Often, a moneylender's clients are from
within his own neighbourhood or at least nearby, so that the moneylender
can keep an eye on their activities and whereabouts. Repeat lending - a
phenomenon in which a moneylender lends funds to individuals to whom
he has lent before or has close interactions with - is very common. Aleem
(1993) found in Chambar that as many as 10 out of 14 moneylenders
surveyed lent more than 75 per cent of their funds to old clients. Even
among the remaining four lenders, the lowest percentage of repeat lending
was reported to be 52 per cent. They insist that the borrowers deal with
them exclusively, i.e., approach no other lender for supplementary loans.
These features of informal credit markets imply that such markets cannot
be regarded as competitive simply by counting the number of active
lenders and borrowers because although there may be a backdrop of
competition, particular dealings are often (though not always) bilateral.
Informational, geographical and historical advantages often tend to confer
the blessings of a local monopoly on lenders, which they are not slow to
exploit.
13. Contract enforcement mechanisms
Social sanction and market limitations are the most common
instruments for the enforcement of contracts and the recovery of loans.
Recourse to the legal system of the country is uncommon since such
financing is by its very nature conducted without reference to the legal
system. However, the meaning and use of social sanction is specific to the
31
Often, a
moneylender's
clients are from
within his own
neighbourhood
or at least
nearby, so that
the moneylender
can keep an eye
on their
activities and
whereabouts.
type of lender. Commission agents and input dealers usually extend credit
without any collateral or written agreement. Recovering loans is generally a
smooth process since farmers usually return the borrowed amount to
maintain a good relationship with the dealers in view of their future needs
for credit. Recovery of a full loan is naturally very difficult in case of crop
failure and lenders have to wait till the next crop. Some lenders, however,
do adjust loans by transferring the property of the borrowers in their
name. Some moneylenders extend loans through mediators, local
councillors or landlords and recover their loans by using the influence of
these intermediaries. Indeed, a few moneylenders were found to be
powerful enough to force borrowers to hand over jewellery, livestock and
farm machinery in order to adjust the loans. In some cases, even land was
acquired from borrowers by moneylenders in lieu of the loan. Another
phenomenon in these areas was the emergence of powerful landlords with
political standing either as moneylenders themselves or through their
agents.
Moneylenders usually take various precautionary measures before
taking on a new client. These almost invariably include the practice of
dealing with the potential client in other markets (for example, employing
him on his farm or purchasing crops from him) for some period before
advancing a loan, if at all. This is done in order to gather reliable
information about the potential client's alertness, honesty and repayment
ability. In addition, moneylenders also extensively scrutinise new clients by
visiting their neighbourhood and conducting interviews with his
neighbours and previous business partners to assess his reliability and
character. Such interaction carries a high opportunity cost due to the
considerable amount of time involved in information collection.
A few
moneylenders
were found to be
powerful enough
to force
borrowers to
hand over
jewellery,
livestock, farm
machinery or
even land in
order to adjust
the loans.
Aleem (1990) found that if, after the intense screening and period
of waiting, the lender agrees to advance a loan (the rejection rate of new
loan applications was around 50 per cent), he usually begins with a small
'testing loan'. After all, the most reliable information about a trading
partner's characteristics can come from the experience of actually dealing
with him; no number of enquiries can reveal what actual interaction will
tell. Carrying out transactions with the person concerned is, therefore, the
32
A Study of Informal Finance Markets in Pakistan
ultimate 'experiment' that will reveal his characteristics. However, the
experiment is risky and hence lenders exercise caution at the beginning.
Only when the testing loan is duly repaid does the lender increase his trust
in the client and increase the loan amount to match the latter's needs.
The sharp segmentation and exclusivity of informal credit
markets induce most borrowers to comply with contractual terms: a
defaulting borrower, who is removed from the good books of his current
lender, will find it extremely difficult to find a new source. Thus, apparent
competition between lenders and free access to multiple sources is actually
restricted due to informational limitations and this is what helps discipline
most borrowers. In urban business transactions, the caste system also plays
a large role as it is easy for certain business communities to develop trust
and enforce contracts. While contracts do take some formal shape,
ultimately, it is reputation which counts. Certain markets are just like a
perfect information market where every player knows how good the other
player is. In an environment of weak contractual enforcement, those
engaged in business (especially arms-length transactions) have to be very
discreet and often rely on individual goodwill and on social pressure in the
absence of security or collateral. In cases of default, market associations
normally mediate and decide about receivables and payables. In extreme
circumstances, they may even dispose of assets. Social and political
influence does give an edge in business dealings.
The use (or threat of use) of force is also a potent instrument for
enforcing contracts or ensuring payment when all else fails. The mere
reputation of willingness and capacity to use coercive means, if credible, is
often enough to ensure that contracts are respected. There is considerable
anecdotal evidence that the intermediation of state agencies is often also
used by influential parties for recovery of defaults, gaining possession of
property, forcing sale on low prices, or for getting out of a contract. But
such intermediation does not always yield the required results. In many
urban areas, there are now organised groups that offer their services for a
fee in order to force recovery. These groups charge anywhere from 10 per
cent to 50 per cent of the amount involved for their services. Among the
tactics that they use are threats, abduction, illegal confinement, torture and
33
The sharp
segmentation
and exclusivity
of informal
credit markets
induce most
borrowers to
comply with
contractual
terms.
other forms of coercion.
14. Implications for policymakers and the microfinance sector
It is not possible to wish away informal finance markets.
Policymakers need to realise that so long as institutional finance has
limited access and does not fully meet the demand of the client, the
informal financial sector will continue to flourish. Attempts to cap
interest rates charged in informal finance markets or an outright ban of
certain IFMs are therefore not likely to yield results. This is because these
defy economic logic and the weak institutional arrangement for
implementation may, in fact, raise the transaction costs of doing
business in IFMs. A better economic response to the existence of such
markets may be to develop more linkages between the formal and
informal markets, speed up financial liberalisation and encourage the
deepening of formal finance markets.
A long-term strategy in deepening the financial market should
focus on institutional reforms which address the information problems
in financial markets that are primarily responsible for market failures.
Such reforms should also focus on exploring ways to create an enabling
environment for private sector participation in microfinance and on
enhancing the sustainability of the microfinance sector. This may
involve providing the right incentives (avoiding subsidies and bailouts
that distort incentives), and creating institutions that promote
transparency through oversight and prudential regulation.
Policymakers
need to realise
that so long as
institutional
finance has
limited access
and does not
fully meet the
demand of the
client, the
informal
financial sector
will continue to
flourish.
A key policy question regarding the interlinkage of formal and
informal finance markets is to determine whether and to what extent
these complement or substitute each other. If complementary, then
policies need to focus on eliminating distortions in both markets and
simultaneously encouraging both to grow. But if the two are strong
substitutes for one another, the question becomes one of evaluating
which markets are better at achieving any given economic objectives and
designing policies aimed at improving their efficacy. For instance, it
appears that IFMs tend to have a greater informational advantage:
instead of trying to replace them, one response could be to encourage
34
A Study of Informal Finance Markets in Pakistan
them by extending formal finance to economic agents who are likely to use
these funds in informal markets. Another response is to actually design and
help expand microfinance institutions that will take advantage of locallevel information.
There is evidence of some interlinkages between formal and
informal credit institutions in Pakistan. Aleem (1990) argues that lenders
sometimes borrow from the informal market and then lend at an even
higher interest rate. According to the Survey of Informal Lenders (1996),
around one-third of the credit extended by informal lenders is provided by
formal sector institutions such as banks. Processing units, landlords and
other influential persons borrow from banks for onward lending through
informal channels. One way of expanding formal credit through informal
agents is through servicing the aartis. Regarding the disconnect between
aartis and commercial banks, the Committee on Rural Finance ascribed it
to the lack of interest by commercial banks in pursuing this line of client.
The survey of informal urban markets conducted for this study,
however, suggested that there may be little competition between suppliers
of formal and informal credit since banks cannot adequately cater to the
demand in such markets. This implies that the formal and informal credit
markets are more often complementary rather than substitutes: there may
often be no link between the two at all as borrowers have access to only one
or the other. However this is an issue on which there is need to conduct
empirical research.
Another policy question that needs to be explored empirically, as
this has a bearing on the case for subsidised credit, relates to the
responsiveness of the demand for credit to changes in the interest rate.
“Practitioners in Bangladesh tend to believe that the elasticity of credit
demand with respect to the interest rate is high and accordingly they keep
interest rates relatively low (below 25 percent real). Practitioners in Latin
America tend to believe that the elasticity is low, and they set interest rates
as high as needed (approaching 60 percent real). Both could be correct in
their contexts, but serious empirical work is lacking,” (Morduch 1999).
This question has a bearing on the issue of what interest rates to charge and
35
A key policy
question
regarding the
interlinkage of
formal and
informal finance
markets is to
determine
whether and to
what extent
these
complement or
substitute each
other.
whether or not to subsidise credit. If it is true that the credit demand by
poor borrowers is not very sensitive to the interest rate, then pushing for
financial sustainability should not limit the depth of outreach by much and
the case for subsidisation weakens considerably. Regarding the impact of
expansion of formal finance on informal finance, there are some
theoretical models but few empirical studies.
A recurrent theme that emerged in this study was the weak
contractual environment pervasive in both urban and rural areas - a
particularly binding constraint to business development. This weak
environment creates an atmosphere of low trust and manifests itself in
many ways, especially in hindering business expansion for SMEs and the
informal sector. It is a factor of mostly poor judicial enforcement rather
than inadequate legal rules. Poorly enforceable property rights and the lack
of a fair, efficient and cost-effective judicial system result in an
unpredictable environment hampering business expansion, leading to
distortions in the business structure, sub-optimal decisions arising from a
desire to secure contracts (for example, vertical integration without any
competitive advantage, retailers taking up manufacturing to secure supply
lines and so on), and a reluctance to enter into long-term contractual
arrangements3.
In terms of urban informal sector financing, access to credit is
only one of the constraints. Other constraints are lack of market access
and participation, lack of technology and skills, high transaction costs and
transportation costs, lack of bargaining power and representation, an
unfavourable legal, policy and regulatory environment, and biases in
existing private sector development strategies. Whereas some of these
constraints can be addressed through financial and business development
services, others can only be addressed through changes in the investment
climate or wider business environment. This suggests that the most
important intervention for business expansion is improving the wider
investment climate and reducing the cost of doing business. For the
informal sector and the micro-enterprises, it is far more important to
remove the policy biases and specific constraints against these sectors and
to establish a level playing field than to institute preferential policies
A recurrent
theme that
emerged in this
study was the
weak
contractual
environment
pervasive in
both urban and
rural areas.
36
A Study of Informal Finance Markets in Pakistan
seeking to promote these sectors, which may not be justifiable on grounds
of economic efficiency.
A study of IFMs can help microfinance institutions (MFIs) in
understanding their market, developing their core niche, exploring the
options for cross-subsidisation between markets and developing viable
and demand-driven products and practices. This can help the sector
outgrow its current small outreach to a more sustainable size. “For
microfinance institutions, the lessons are to build long term, credible
partnerships. The belief that the accumulated benefits associated with
continued long-term transactions are larger than short-term gains
associated with delinquent behavior is what propels self-enforceability of
most informal institutions. Formal institutions also need to successfully
demonstrate to clients … that they are not transitory phenomena and that
it is worthwhile for them to invest in a long-term, profitable relationship.
This demonstration is essential for maintaining high repayment rates.
Short-term and sporadically implemented “credit projects” generally
encounter higher rates of loan delinquency precisely because short-run
gains associated with default outweigh extremely uncertain future gains”
(Sharma, 2000).
MFIs need to learn to tailor financial services to specific demand
patterns from informal finance markets. Although microfinance can help
the poor smooth consumption and make productive investments,
microfinance cannot be a solution to all their financial intermediation
needs. In the long run, even the sustainability of microfinance requires a
shift away from a supply focus to a demand-driven market system. This is
especially important in the rural areas where financial markets seem to have
thinned instead of having deepened during the 1990s, as indicated by a
decline in the number of banks and a fall in the share of commercial
funding in total agriculture credit. MFIs can expand recent innovative
experiments involving microfinance and land allocation (Gazdar, Khan
and Khan, 2002).
MFIs can also reap the advantages of clustering. Clusters are
geographically concentrated systems of interconnected firms and
37
The most
important
intervention for
business
expansion is
improving the
wider
investment
climate and
reducing the cost
of doing
business.
institutions in a particular field, which face common opportunities and
threats and are linked by commonalities and complementarities. Many
informal firms typically operate in clusters, with the geographical
boundary delineating an 'internal' market for all kinds of activities. Its
advantage results from reductions in transport costs and from a relatively
easier access to credit from informal sources, since information about
borrowers is more easily available within the cluster. Clustering also makes
a larger pool of labour, with expertise available in the activities carried on
within the cluster. Successful clusters upgrade over time by channelling
competitive pressures into enhanced productivity. Moreover, clustering is a
mechanism that reduces the transaction costs of doing business and
obtaining access to credit either through financing co-operatives
(associations of cluster firms) or financing individual firms in clusters
while using the cluster associations for generating external economies.
This results in better screening, monitoring of clients and facilitated
repayment mechanisms.
There is
tremendous
potential in
Pakistan for
MFIs to
collaborate with
public or
private agencies.
There is tremendous potential in Pakistan for MFIs to collaborate
with public or private agencies through targeted, competitive and marketdriven public interventions in upgrading existing clusters or kick-starting
the growth of new cluster through a catalytic effect. Some recent initiatives
in Pakistan highlight the possibilities of this approach. A recent initiative
of the Punjab Government titled the “Cluster Development Program for
Small and Medium Enterprises” involves collaboration between the
Pakistan Small Industries Corporation (PSIC), United Nations
International Development Organisation (UNIDO) and Small and
Medium Enterprises Development Authority (SMEDA) for the
development of seven existing clusters in the Punjab. Another initiative,
one of the best examples of successfully using the cluster approach to
finance micro-enterprises, is the Bank of Khyber's financing of a big
weaving cluster in Matta Mughal Khel, Charsadda. A study of this
endeavour clearly revealed its effectiveness in raising local incomes and
upgrading the cluster. Clusters make it easy for a MFI to develop a
customised financial product that not only caters to the business needs of
the cluster firms, but also utilises the informational and commitment
advantages which make screening and recovery easy. MFIs can collaborate
38
A Study of Informal Finance Markets in Pakistan
with either commercial banks or public agencies on cluster development
programmes. Meanwhile, the Pakistan Microfinance Network can
facilitate this process by conducting studies on existing clusters and
suggesting models of such collaborations.
Another option for MFIs is to implant themselves into the entire
suppliers' chain through those who provide embedded services or business
development services. These include informally provided services such as
knowledge and advice available to small businesses through business and
social relationships (for example, family, friends, social networks and
associations), design specifications, access to raw materials, capital and
markets, training, storage, and transportation services. One good example
of embedded services leading to enhancement in productivity and to a
mutually beneficial relationship is the Idara Kissan model where the Idara
is providing veterinary and social services to milk producers. There is a
potential for collaboration between institutions providing embedded
services as part of their business strategy or mission and MFIs.
Finally, MFIs have a unique opportunity at present to venture into
the area of SME lending by using the soft information available to them.
Bari and Faheem argue in this study that MFIs can trade on this
information by either renting out their ability to use social collateral or by
going into SME lending themselves. This soft information, due to MFIs'
grass-roots presence, established reputations and extensive knowledge and
relationship with the people and enterprises in an area, enables them to
utilise social collateral as a valid means of control. Moreover, they have
staff members that are trained in developing and using soft information as
well as using cash flow-based lending, and an institutional structure that
does not discourage smaller borrowers from approaching them.
In the first option, MFIs cannot only become information
providers to banks and/or partners of banks which need credible soft
information, but also act as levers by which this information can be used to
avoid default and thus generate extra resources from existing information
and knowledge. Another option is for MFIs to go directly into SME
lending. This option carries higher risks but promises higher returns as well
39
One good
example of
embedded
services leading
to enhancement
in productivity
and to a
mutually
beneficial
relationship is
the Idara Kissan
model.
and could be a strategy for achieving financial sustainability and portfolio
diversification. For this option, MFIs need to have marketable products
and services as well as trained staff to deal with established business
enterprises. This strategy implies a significant change in the organisational
structure, client base and priorities of MFIs. This may not suit MFIs trying
to reach the very poor but could work well for MFIs that fund existing
micro- and small businesses
Both these options need to be explored further. The Pakistan
Microfinance Network can take the lead and initiate a dialogue as well as
further research on their prospects. MFIs can explore different models of
the contractual nature of their relationship with commercial banks while
the PMN can support pilot testing of innovations. Such experimentation,
although carrying its own risks, can potentially help MFIs to meet the goals
of expansion and sustainability.
Another option
is for MFIs to go
directly into
SME lending.
40
A Study of Informal Finance Markets in Pakistan
Notes
1
Hawala literally means 'trust' and 'exchange'.
2
This is worked out by assuming that 75 per cent of total farms in Pakistan
are potential clients needing agriculture credit. According to the 1990
Agriculture Census, the total number of farms in Pakistan is 5.07 million
and the potential clients come out to 3.8 million and the ratio of actual
borrowers comes to 15 per cent.
3
According to the World Bank (2003), surveys suggest that: (a) most SMEs
are limited to dealing with a handful of stable suppliers and buyers
depending on long-term stable relationships with a small number of
clients that have been developed on the basis of reciprocity rather than on
general trust; (b) there is a lack of trust of government; and (c) there is
limited faith in the formal adjudication systems to settle disputes quickly
and to enforce contractual obligations in a predictable manner, resulting in
uneven reliance on long-term contracts. The decision to either rely on
informal mechanisms to enforce contracts or to carry out transactions only
with those, whose business ethics one trusts, segments markets, raises
transaction cost of organising large-scale production and exchange and
discourages business development.
41
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47
Annex A
Micro-Finance Institutions (MFIs) and Small and Medium
Enterprises (SMEs)
Faisal Bari and Adeel Faheem
1. Introduction
There are tremendous opportunities for micro-finance
institutions (MFIs) to explore the credit market for small and medium
enterprises (SMEs)1, especially the smaller and micro-enterprises. SMEs
are credit constrained and smaller enterprises are even more credit
constrained than the larger ones. The main reasons for the credit rationing
of SMEs by large lending institutions in the formal sector are largely due to
,
a lack of physical collateral that SMEs can offer as guarantee for loans as
well as a lack of access to credible information about the SME on the part
of the potential lender. These factors are embedded in a legal and judicial
structure that does not protect property rights effectively, which makes
enforcement of contracts very costly as well as unpredictable. Given the
above, many banks shy away from lending to SMEs even when personal
guarantees are available. MFIs have some very specific advantages in this
regard. They have more presence in local areas, access to the use of social
collateral, better information on the potential borrowers as well as about
their reputation in the area, and know potential guarantors better as well.
MFIs can thus a) trade on this information to become information
providers to the larger banks, or b) go into lending to SMEs directly. There
are quite a few such examples available from around the world. Both
strategies will allow a diversification of the MFI portfolio and can give
additional sources of revenue to the MFI while exploiting existing
information. The Government of Pakistan (GoP) is currently looking for
ways of increasing financing for SMEs and easing their credit constraints.
Furthermore, various formal sector banks are also trying to establish
themselves in this market. This seems like an opportune moment for some
MFIs to explore the possibility of link-ups and partnerships.
In this chapter we establish the credit constraints of SMEs, the
nature of the constraints, and identify where MFIs can help become part
of the solution. Using several surveys available to us we establish in section
49
2, that SMEs are indeed credit constrained2 and the smaller firms are more
constrained than the larger ones. Section 3 will show, using the same
surveys, what the exact nature of these constraints is. Section 4 will provide
a conceptual framework for looking at the problem and identify where
MFIs can successfully explore possibilities. We conclude in section 5.
2. Trends and modes of financing SMEs
We use data from three different surveys to establish some results
regarding financing patterns. This is done not only to cross-verify the
results but to show that though all three surveys are based on small
samples, compared to the vast universe constituting the totality of SMEs in
Pakistan, they represent results of which there is no need to assume are
atypical of the larger body. These surveys are:
3
a)
A 60-firm survey that was conducted in 2002 for a study for the
Asian Development Bank (ADB) with the purpose of trying to understand
what factors were constraining the growth of SMEs in Pakistan. These
firms were mostly from Lahore, Karachi and Gujranwala.
b)
An 80-firm survey conducted in 2004 for the Securities and
Exchange Commission of Pakistan (SECP)4 to understand obstacles in the
way of the incorporation of SMEs. This survey included firms from
Quetta and Peshawar in addition to the cities mentioned above.
c)
A 650-firm survey conducted in 2003 by the Small and Medium
Enterprise Center (SMEC) at the Lahore University of Management
Sciences (LUMS). This survey was conducted to establish a baseline for
some of the salient features of SMEs in Pakistan. This sample was from
across Pakistan.
Firms need funds for capital expenditure and expansion
(medium- and long-term lending) as well as for working capital (short
term) requirements. We analyse the lending pattern of both types of
financing. The available literature5 also points out that access to finance is
linked to the size of firm, legal structure, age of business, and the sector
that the firm belongs to. We analyse borrowing patterns along all of these
50
A Study of Informal Finance Markets in Pakistan
dimensions.
2.1. Credit Rationing
For SMEs most of the resources for financing long-term fixed
investments come from retained earnings, personal sources, and
borrowing from family and friends. Commercial sources, supplier/buyer
credit, and even the high interest informal market seem to form a very
small source of such funding. According to Bari et. al (2003) 55.7 per cent
of the funds for fixed investment, for the sample firms, came from selffinanced sources; 19.3 per cent from retaining earnings; and 4.6 per cent
from friends and family (Table 1 below). Commercial banks only
contributed 6.1 per cent of the financing.
The percentage of self-financing is larger for smaller firms and
drops significantly with size. Retained earnings form a bigger source for
larger firms, though commercial banks also increase their funding
percentage for larger firms. Trade credit and local moneylenders remain a
very small part of the financing spread.
This pattern was consistent across the data sets as well. Of the 278
firms that responded to questions on fixed investment, 60 per cent said
they financed their fixed investments through personal sources and only
15 per cent got financing from commercial banks, while 15 per cent
borrowed from friends and family.
For working capital the pattern is slightly different: the percentage
from commercial sources is somewhat higher. This is to be expected as
working capital loans are better secured and less risky compared to fixed
investment loans. Even then the percentage is not significantly different
and the bulk of the financing comes from retained earnings and selffinancing. There is again a clear pattern based on size of firm. As the firm
size goes up a larger percentage of funds is secured from commercial
banks. There is a larger role for trade credit in working capital. Since these
are short-term loans and are needed on more flexible basis, this is again to
be expected. Paying higher interest is justified from the borrowers side on
the basis of the short time period involved while the lender is covered due
51
to the better security available in case of working capital loans.
Table 1: Sources of Finance (% of investment financed)
II. Sources of Working Capital
Investment
I. Sources of Fixed Investment
.
Financial
Information
Retained earnings
Commercial banks
DFIs
Lease
Self-financing
Pooled
SME
sample
19.3
6.1
0
14.3
55.7
Small
12.5
9.4
0
2.5
67.5
Medium
30.7
7.1
0
25.7
36.4
Large
32.1
20.3
0
9.1
34.4
Local moneylenders
Family/friends
0
4.6
0
8.1
0
0
0.6
3.2
0
0
0
0.3
Total
100
100
100
100
Retained earnings
62.9
66.3
56.4
40.9
Commercial banks
DFIs
Lease
Self-financing
11.8
0
5
0
26.4
0
40.9
0
18.9
26.9
2.1
8.8
Local moneylenders
Family/friends
5.4
1.1
0
1.9
10.7
4.3
7.9
0
0
100
0
100
0
100
1.5
100
Trade credit
Trade credit
Total
Source: Bari, et al. (2003)
52
A Study of Informal Finance Markets in Pakistan
Again the pattern of financing is consistent with the one reported by the
650-firm data set. Out of 363 firms, 50 per cent financed their working
capital needs from their own funds and 18 per cent received it from
commercial banks, while 20 per cent raised money from family and friends.
The share of informal markets and trade credit was quite small.
Table 1 and the larger data set show that firms do not use
commercial banks very often. But this argument does not establish the fact
that firms are credit constrained or rationed. The above pattern would be
consistent with the possibility that the demand for loans from SMEs, for
both working capital as well as fixed investment, might be low and it is not
the supply side that is creating the constraint. To explore this possibility we
can report financing patterns on the basis of size too. If the problem is
with demand there should not be a very significant pattern based on size.
But if there is credit rationing and larger firms are in a better position to
acquire credit and ration out smaller firms, we would see a clear direct
correlation between size of firm and percentage of funds from sector
banks. We have already seen some correlation of size and financing pattern
in Table 1. Table 2 makes the relationship more explicit.
Table 2: Percentage of Manufacturing and Export SMEs that Ever
Received Formal Bank Credit by Size and Age of Firm
Size of Firm
(number of
employees)
Age of Firm (years)
0 to 5
0 to 10
0%
11 to 49
0%
50 to 99
100%
100 or more
100%
All Sizes
50%
Source: Bari et al. (2003)
53
6 to 10
11 to 20
0%
35%
67%
75%
67%
0%
0%
75%
75%
64%
21 &
more
0%
0%
15%
83%
50%
All Firms
0%
29%
50%
80%
59%
Table 2 shows that there is a clear correlation between size of
firms and access to credit. As firms get larger their access to finance gets
better. This shows that smaller firms are indeed credit rationed and have to
rely on retained earnings and personal sources to finance investment and
expansion as well as working capital needs. This could be an important
growth constraint on smaller firms.
The literature on financing patterns also shows that as firms get
older they are not only able to access credit markets more, but are able to
get better terms and conditions from lenders. But Table 2 does not show
the expected pattern. The key problem here is that age can only matter if
there is an accumulation of credit history and history of a working
relationship with a lender. If the small firm stays in the informal sector,
does not have access to credit registries to establish a track record with, and
does not have a long-term relationship with a bank, age will give no
advantage in terms of access to finance. It is only for firms in such
relationships, as found by Siddique and Bari (2004), that access does
improve.
2.2 Legal Status/Structure of SMEs
The literature on firm financing also points out a connection
between the legal status of firms and access to finance. Firms that are
incorporated under the more formal laws such as the Companies
Ordinance - since they are required to have better records, get audits done,
make more information public and be more transparent - should have
more credible information available to share with banks and so should find
it easier to get access to credit. But we do not find much evidence for this
relationship within our samples. Siddique and Bari (2004) analyse the
change in the pattern of financing due to a change in the legal identity of
the firms. They find no significant relationship between the two. In their
sample of 80 firms, only 40 firms approached banks for loans. Of those 40
firms that approached banks, more than 50 per cent (25 firms) of the firms
belonged to the sole proprietorship and partnership classes. Only 11 firms
are private limited companies. The firms that never approached banks
consisted of 38 sole proprietorships and partnerships and two private
limited companies. The new SME prudential regulations set out by the
54
A Study of Informal Finance Markets in Pakistan
State Bank of Pakistan (SBP)6 mandate lenders to acquire personal
guarantees from all SMEs irrespective of their legal status. This takes away
any limited liability advantages that were available from incorporation
anyway. The National Accountability Bureau (NAB) law also does the
same. Thus even if there were any benefits from incorporation, they have
been diluted by recent regulatory changes and it is not surprising that no
correlation is found in the data.
Table 3: Advantages Due to Legal Structure vis-à-vis Approaching Banks
for Financing
Legal Structure
Sole
proprietorship
Partnership
Single member
company
Private ltd
company
Unlisted public ltd
company
Approached
Banks
Never
Approached
Banks
Those Facing
Problems
7
8
19
8
1
2
1
…
…
8
1
…
3
…
1
Source: Siddique and Bari (2004)
Both Bari et. al (2003) and Siddique and Bari (2004) show that
even manufacturing SMEs find it easier to acquire credit from formal
sector lenders than service, especially retail sector firms. This has to do
with the relative ease with which manufacturing sector firms can post
physical collateral compared to retail/trade firms.
From the above analysis we can conclude the following:
55
SMEs are 'credit constrained' in the sense that at prevailing
interest rates they are willing to borrow and/or borrow more but
do not have access to funds and thus get credit rationed.
SMEs do not approach formal sector financial institutions very
often and the smaller firms, even within the SME sector, approach
them even less.
Within SMEs, manufacturing firms find it easier to obtain finance
from the formal sector institutions compared to firms from the
service sector.
The legal structure (sole proprietor, partnership, limited
company) or age of SME firms seems to have little or no bearing
on its ability to obtain finance.
For SME firms that have received loans from formal institutions,
working capital loans constitute a higher percentage of loans than
long-term fixed investments.
Supplier/buyer or trade credit forms a small part of SME firms'
total credit portfolio.
Personal sources, retained earnings from the business, and loans
from family/friends form the bulk of investible resources for
SMEs. The first two are the main contributing heads for most
firms. Large firms use formal sector credit providers much more
heavily.
High interest commercial but informal credit markets form a
negligible source of credit funds for SMEs.
In the next section, we identify some of the constraints that have
been mentioned by SMEs as the major reasons for their inability to get
access to finance from formal sector institutions. An analysis of these
constraints will set up our discussion for the space that MFIs have in
addressing some of these issues and getting a foothold in this market.
3. Constraints to SME finance
The major constraints faced by SME firms in obtaining finance
7
from formal sector financial institutions are listed in the table below :
56
A Study of Informal Finance Markets in Pakistan
Table 4: Size-specific Rankings of Financial Constraints8
(average scores on a 1-5 scale)
Firm size ranked by constraint level
Financial Constraints
Formal Sector Credit
Collateral requirements
Need for credit history
Connections with credit
agencies
Delays in obtaining
loans
Lack of access to credit
High interest rates*
Corruption in obtaining
finance
Highest
Pooled SME
sample
Small
Medium
Large
4.4
3.1
3.8
4.8
3.2
4.2
4.1
3.1
3.4
3.1
2.3
1.8
4.3
5.0
3.6
2.9
3.8
3.5
3.8
4.3
3.1
3.9
3.6
4.0
3.7
2.7
4.3
1.3
2nd Highest
Lowest
Source: Bari et. al. (2003)
*This survey was conducted in 2001-2002. Since then interest rates have come down
significantly, and this does not remain a binding constraint in recent surveys like Siddique
and Bari (2004).
None of the constraints mentioned above were reported as
binding for large firms while they were almost all binding for small and
medium firms. There is a clear trend in the reported severity of the
constraint too: small firms found the constraint to be more binding than
even the medium-level firms.
Lending to SMEs in an environment where property rights are
weak, contract enforcement unpredictable and costly, knowledge about
firms as well as sectors in which firms work opaque, incomplete, nontransparent and non-verifiable forces lenders to ration SMEs out, or
57
require extra collateral and guarantees as well as demand a high level of
documentation. The small asset base of SMEs makes it difficult for them
to collateralise loans and personal guarantees (or rights over personal
assets) raise the risk levels for entrepreneurs9. The table below shows that
out of 510 loan applications, 300 had to furnish collateral in the form of
personal land or money. Smaller firms also find it costly to institute and
provide sufficient documentation. The constraints become weaker for
medium and large firms.
Table 5: Security Requirements for Bank Loans
Whatever
Total no.
the
of male/
Assets of Registry security OD. is given At
female
Personal
the
of the bank
as the basis of personal
employees land/money company house demands transaction
guarantee
7 to 10
166
94
6
6
1
2
Total
275
11 to 20
91
60
1
1
0
0
153
21 to 30
23
25
1
0
0
0
49
31 to 50
Total
20
300
13
192
0
8
0
7
0
1
0
2
33
510
Source: Author analysis based on the SMEC survey of 650 firms
A delay in obtaining loans causes significant problems for SMEs.
Commercial banks have lengthy procedures and significant
documentation requirements before they can release funds. These
procedures take longer for firms that are owned by less educated people
(there is strong correlation between the size of the firm and the
educational attainment of the owner) and are smaller or have not had
previous dealings with banks. So delay and previous experience becomes a
58
A Study of Informal Finance Markets in Pakistan
significant entry barrier. Formal sector banks also do not have credit
officers that can help and advise entrepreneurs in filling forms and meeting
bank requirements. Table 6 below shows that out of 405 firms, only 17 per
cent expected their loan applications to be processed and be able to obtain
financing within 15 days of filing their applications. For the rest the delay
expectation ranged between 16 to 1,080 days. Most firms expected a oneto three-month processing time for loan applications. Clearly this is too
long a wait for small firms that are cash-strapped most of the time, and
have to deal with emergencies all the time.
Table 6: Firms' Expectation of Number of Days (after applying) Required
to Acquire Loan from Banks
Total No. of
male/
female
employees
7 to 10
11 to 20
21 to 30
31 to 50
Total
1 to 15
36
26
6
2
70
16 to 30
53
44
9
7
113
31 to 90
68
36
15
14
133
91 to 1080
52
19
14
4
89
Total
209
125
44
27
405
Source: Based on the survey of 650 firms by SMEC
The remaining factors mentioned do not require any elaboration.
The literature on constraints shows that if these firms are at all entertained
by banks, they have to post collaterals which they do not usually possess,
deal with delays in obtaining finance and have difficulty in meeting the
documentation requirements of banks. Moreover, firms believe that they
need to have connections with lending agencies in order to obtain loans.
These factors, coupled with the fact of credit rationing, open up certain
opportunities for MFIs. We discuss these in the following section.
59
4. Implications for MFIs
Pakistani institutions, whether they are firms or banks, work in an
environment where property rights are not secure, contract enforcement is
weak, and legal recourse in case of a dispute is not only costly and lengthy
but uncertain as well. This makes contracting across time that much harder
and requiring extra guarantees. There is not much of a problem with onthe-spot transactions as they do not depend on the legal and judicial
environment much as long as proper inspection costs are instituted from
the start. But when contracting has to be done across time, firms will either
have to build extra leeway or avoid such contracting. While both options
are more costly, given the incomplete contracting environment, they are
the only options open to firms. This is one reason that asset-specific
investments are less common in Pakistan, sub-contracting does not
happen across all industries and in proportions that we see in Taiwan,
Korea and other developing countries, and the cost of transactions tends
to be higher. Bari et. al (2003) provides a detailed discussion on the issue.
10
Firms can develop 'trust' networks based on repeated interactions but
these require significant switching costs to be successful. A lot of the
sectors that we are talking about are fairly competitive and have a large
number of potential suppliers and buyers. Thus repeated interactions do
not mean development of trust since there is no 'investment' in the current
period game possible that can credibly predict future behavior.
Credit extension is the quintessential across-time activity. The
lender gives money today and the payback comes after a period. If the
contract is not backed by an efficient property rights and contract
enforcement regime the risk of the lender for willful default increases and
so will the cost for the lender. This is the situation that Pakistani lenders
face. Banks use two ways to cover this risk. First, if they can collateralise the
loan with an asset that can be taken away from the borrower in case of
default and can be disposed of, they are safe. But for this to happen they
have to have collateral that is large enough to cover the loan, the interest
they expect from the loan, and the cost they expect to incur in acquiring
and selling the asset in case of default. The more problematic the legal
environment the larger will be the collateral required. This becomes a
stumbling block for most SMEs since they are usually too small to be able
60
A Study of Informal Finance Markets in Pakistan
to furnish such collaterals. Furthermore large banks can only use physical
assets as collateral as they do not have the local presence to be able to use
reputation and reciprocity relations as collateral. Only smaller and more
local institutions can do this. We will return to this point when we discuss
the opportunities for MFIs.
The other way banks can cover their risk is by having excellent
verifiable knowledge about the actions of the borrower and the ability to
monitor his/her actions. Knowledge can be based on public sources of
information, access to firm accounts and company internal papers, but its
verifiability depends crucially on third-party validation since banks cannot
possibly verify all the information about all of its clients. These banks rely
on third parties such as independent auditors, reports to the SECP, stock
prices, and other such information but smaller firms usually do not have
such information available. Smaller firms are not well documented, are not
required by law to have third-party validation, and are not mandated to
provide publicly available information about their business. Here banks
have to rely crucially on the information provided by the clients themselves
and on verifications that the bank can make itself. Similarly the ability to
monitor actions of a small firm is going to be less than the ability to
monitor actions of a large firm. Formal sector banks do not have the
density of credit officers that can give them the ability to follow every
client. The cost to do so would be high.
The upshot of this is that formal sector banks, interested in
maximising profits, will ration out smaller firms as a part of their profitmaximising strategy as they would prefer to focus on larger clients and
larger loans so that the cost of transactions can be minimised. The weaker
the legal/judicial environment of a country the more binding would be
this pattern. This is exactly why we find commercial banks rationing
smaller firms more than larger firms in Pakistan. It is true that as
competition for clients gets more strenuous due to more competition
between banks, some banks will be forced to move towards riskier clients
but the discrimination against the smaller player will continue.
61
The reasoning given above is further strengthened by the way
prudential regulations on lending have been shaped. Till recently banks
were not allowed to lend to firms on the basis of cash flows - they had to
have collateral-based lending. Although the SBP has now allowed
programme lending and cash flow-based lending, there is a dearth of staff
that knows how to do cash-flow lending and there have been no training
courses arranged as yet introducing the staff to the tools they need. Formal
sector banks are still organised in a way that favours bigger clients.
Branches are in areas that are closer to larger clients, credit officers are
trained to deal with corporate leaders, and the name of the game is still the
size of the individual loan. There are some banks that are making extra
efforts to reach out to SMEs for example, Habib Bank, NIB and Union
Bank, but these efforts are still small and will do nothing to alleviate the
credit constraints of most of the SMEs in the country. In particular, none
of these banks are reaching out to the smaller and micro-firms as yet.
One way of conceptually looking at the issue is through the model
given as Figure 1 at the end of the chapter11. Financial institutions,
whatever their size or ownership structure, depend on the lending
infrastructure to make decisions about what sort of information they are
going to need to reach a particular client. If the lending infrastructure
(availability of verifiable information, commercial law, regulatory
environment, bankruptcy system, and so on) is weak, as it is in Pakistan, the
bank needs more protection. Lending technologies depend crucially on the
availability of 'hard information' or information that is verifiable and
validated by a third party. This becomes especially important if the
infrastructure is weak. But for any given level of infrastructure, if hard
information is not available, the bank has to rely on soft information such
as personal relationship and social collateral. In fact, if the infrastructure is
weaker - even if hard information is available soft information is quite
often required.
If we look at the Pakistani situation we can immediately see how
we fit into this conceptual framework and this helps us explain the current
financing patterns as well as the opportunities open to MFIs. Pakistan has a
weak infrastructure for lending and its lenders cannot really rely on hard
62
A Study of Informal Finance Markets in Pakistan
information. Larger banks, however, are also not very suited to collecting
soft information. As a result SMEs get credit rationed and the smaller
firms get more rationed than the larger firms even within the SMEs. It also
explains why more manufacturing sector firms find it easier to get loans,
why age and legal structure has no bearing on SME financing, and why
more working capital loans are available than longer-term fixed investment
loans.
In this environment, MFIs have multiple advantages. First, they
have a grass-roots presence, extensive knowledge of the people and
enterprises in an area, and established reputations as long-term players in
the market in that area. As a result they have credible soft information on
all players, are in reciprocity relationships with many of them, can call
upon social collateral as a valid means of control, have personal
relationships with many players and know the economy of the area well.
They can therefore call upon the more knowledgeable people of the area
to share their information with the bank, have staff members that are
trained in developing and using soft information, have staff that is also
trained in using cash-flow based lending, and have an institutional
structure that does not discourage smaller borrowers from approaching
them. This creates a unique opportunity for MFIs in this area. There are
two ways MFIs can make use of the special position they have.
They can become information providers to and/or partners of
banks. Banks need credible soft information and levers by which this
information can be used to avoid default. MFIs have the information and
the levers and could do with the extra resources that they can generate
from existing information and knowledge. The exact contractual nature of
the relationship can only be worked out with experimentation between
banks and MFIs and cannot be predicted a priori.
MFIs can also go directly into lending to the micro and smaller
enterprises. In this case the MFI bears the entire risk too but the returns
would be higher as well. Most MFIs do not have staff that are trained to
deal with established business enterprises, they also do not have
knowledge of the kind of products that businesses require as well as the
63
kind of services they would need. With staff training, however, some MFIs
could experiment in the area. If successful this could potentially be a
lucrative field for micro-finance institutions and could be a way to achieve
portfolio diversification as well as financial sustainability. Of course, it can
mean a significant change in the MFI organisational structure, client base
and priorities, and it is probably not the ideal move for an MFI trying to
reach the very poor. But it could work well for micro-finance institutions
that fund existing micro and small businesses.
History gives us quite a few examples of both kinds of roles being
played by small players which had similar knowledge and skill bases as
today's' MFIs. The Oath Commissioners (Notary Public) in France used to
provide soft information to potential lenders because they had
information about all contracts of a party in an area and so knew their
financial situation well. Some of these officials even worked as small credit
bureaus. This continued for quite a few decades till institutions that could
take over the market were developed: the government disallowed Notary
Publics from working as banks, though not as providers of information,
after it was realised that their function as a bank implied a conflict of
interest with their function as a Notary Public. In Germany, credit cooperatives worked on this basis to extend credit to local businessmen. The
advantage of the local co-operative was that it had more credible and
verifiable information on local businessmen, the ability to monitor them
and to use social collateral as a means of avoiding willful default. The same
happened in rural Quebec through credit co-operatives, of which some
became larger banks with time. Committees also (RoSCAs and ASCRAs)
work on the same principle. But they are not formal sector institutions in
Pakistan12, do not have the ability to pass on this information to other
people credibly and do not have an institutional structure that has allowed
them to be transformed into permanent institutions so far.
MFIs, individually and collectively, can enter into a dialogue right
now with banks and other lending agencies about the kind of institutional
partnerships mentioned above. The opportunity is there. On way of
tackling this possibility is for MFIs to collectively or through the Pakistan
Micro-Finance Network initiate a dialogue as well as further research on
64
A Study of Informal Finance Markets in Pakistan
this topic. This will give the MFIs new ideas to work with and also
information about how others have, in other times and even in
contemporary setups, used the informational and institutional advantage
to create larger roles for themselves.
5. Conclusion
The GoP has announced its intention of using SMEs as a vehicle
for sustaining high industrial growth and as a means of spreading the fruits
of growth from both the large-scale to the small-scale industries. For this
purpose, the GoP has already created a company to looking after the
technology and human resource needs of SMEs and one for looking into
the infrastructure needs of SMEs. Another company has been formed to
explore the possibility of developing product or industry specific clusters
through industrial estate development. The GoP has also announced that
it is finding ways of improving SME access to finance. For this purpose
they have already announced a Credit Guarantee Scheme and are also
going to be announcing some other initiatives quite soon.
SMEs are credit constrained and the smaller the enterprise the
more binding seems to be the constraint. At the same time it appears that
given the infrastructure lenders have to contend with, lenders will have to
rely heavily on soft information to reach SMEs. But the organisational
structure of existing formal sector banks, their incentives and the training
of the staff either do not encourage banks from entering into SME
lending, nor do they give a comparative advantage to do so either.
At the same time, an analysis of MFI strengths suggests that
micro-finance institutions might have the information as well as the levers
for encouraging compliance that these lenders will need to enter the
market. This gives MFIs a unique opportunity right now. They can a) trade
on the information that they have and rent out their ability to use social
collateral, or b) go into SME lending on their own. This could be a lucrative
market for them but each option bears its own risk as micro-finance
institutions will be going into a territory that few MFIs have tread before.
65
Notes
1
We use the employment criteria usually used in Pakistan to define SMEs.
Micro-enterprises have employment of less than 10. Small firms are in the
10- to-49 employee category, while medium firms are in the 50-to-99
employee category. Firms with 100 or more employees come in the large
firm category. The numbers will vary a bit within particular manufacturing
sectors, and for the service sector, but as a rough identifier this definition
will suffice for our purpose.
2
We use 'credit-constrained' in the sense that though, at the going rate of
interest, the firm would like to borrow or borrow more lenders are not
willing to extend credit to that firm.
3
Bari et. al (2003).
4
Siddique and Bari (2004).
Reviewed in Bari et. al. (2003) for interested readers.
5
6
June 2004 version.
7
Identical constraints have been identified by other surveys as well. This
table gives constraints for manufacturing sector firms, but the constraints
are similar and similarly binding for the retail sector: hence the table for the
retail sector is not given here to avoid repetition.
8
Constraints are marked as binding if they were ranked by a majority of
respondents as greater than 3.5 on a one-to-five scale.
9
Apart from removing limited liability.
10
Repeated games framework.
11
Based on Berger and Udell (2004).
66
A Study of Informal Finance Markets in Pakistan
12
Though India and other countries do have some RoSCAs organised as
companies.
References:
Bari, Faisal, Ali Cheema, and Ehsan-Ul-Haq (2003). “Regulatory
Impediments, Markets Imperfections and Firm Growth: Analyzing the
Constraints to SME growth in Pakistan”. Lahore University of
Management Sciences (LUMS).
Siddique, Osama and Faisal Bari (2004). “ Simplification and Promotion
of Laws and Procedures for Corporatization of Small and Medium
Enterprises (SMEs)”. A Study Conducted for the Ministry of Industries
and Production, Government of Pakistan and Securities and Exchange
Commission of Pakistan (SECP).
Khan, Iqbal M (2004). “Unlocking the Potential of Small Enterprises for
Economic Development”. SURE Publishers, Lahore.
Berger, Allen N. and Gregory F. Udell (2004). “A More Complete
Conceptual Framework for SMEs Finance Presented in World Bank
Conference on Small and Medium Enterprises: Overcoming Growth
Constraints”. World Bank, MC 13-121. October 14-15, 2004.
67
Annex B
Survey of Informal Finance Markets
69
To know the collateral requirements, procedures adopted for
issuance of loans and their recovery
To find out about abut the sources of funds of informal lenders
To ascertain whether informal credit markets are an alternative to
or complement formal credit markets
3. Review of literature
Irfan et al (1999) conducted a study titled “The Structure of
Informal Credit Markets in Pakistan” in which they used a sample size of
1,018 informal lenders scattered in 250 villages in all the four provinces of
Pakistan as well as Azad Jammu and Kashmir (AJK). They selected 599
respondents from the Punjab and AJK while 419 respondents were
selected from Sind, the NWFP and Balochistan. They used a questionnaire
approach for data collection. Later, case studies were also conducted in
order to support the findings of the survey. The specific objectives of the
study included:
To describe the structure of an informal credit market
To examine the sources and cost of funds generated by informal
lenders
To determine the costs of lending
To quantify the interest charged by lenders on the loans
The results showed that nearly two-thirds of the informal lenders
relied on their own sources to run their business, leading to an impression
of little dependence on external sources. One-third of the total funds
utilised in informal credit transactions originated from the formal credit
system. The results regarding cost of borrowing showed that informal
lenders paid less than 19 per cent annual interest on their funds borrowed
from the formal credit institutions while the rate of interest paid on funds
borrowed from informal sources was about 23 per cent. While the
estimated average annual mark-up worked out to 25 per cent, however, this
varied with different inputs. The total transaction cost of informal lenders
on the average constituted only five per cent of the total volume of
lending.
70
A Study of Informal Finance Markets in Pakistan
Hussain and Demaine (1992) conducted a study titled “How
Informal Credit Offers Greater Benefits to Farmers”. The study was made
in the Liaqatpur tehsil of the Raheem Yar Khan district, out of which one
union council “Dashti” out of 22 union councils was selected. Both
farmers and informal lenders participated and the total sample size
consisted of 169 farmers and 22 informal lenders. Using primary and
secondary data, a questionnaire served as the basis for primary data
collection. The specific objectives of the study were as follows:
To determine the credit needs of farmers of different socioeconomic status
To study how successfully these credit needs are being fulfilled
from various sources
To gain a comparative perspective of the functioning of both
formal and informal credit markets
To study the factors influencing the preference of borrowers in
borrowing from formal and informal credit markets
To investigate and understand the nature and potential of
informal credit markets
To prepare a regional credit plan for making improvements in the
credit system
The study results showed that the average credit requirements for
marginal, small-A, small-B, medium and large farmers were 13,624, 20,752,
18,832, 42,143, and 49,917 rupees respectively. The results suggested that
the consumption credit requirements of farmers in all the categories were
successfully fulfilled from various sources. On the other hand, the
production credit requirements of marginal, small and medium farmers
are only being partially fulfilled while the medium and large farmers were
successful in satisfying their credit needs from various formal and informal
sources. There was no significant difference in the total real cost of
borrowing from formal or informal sources.
4. Methodology
Since the main objective of the study was to assess the effective
rate of interest prevailing in the informal credit market, it was therefore
71
divided into rural and urban sectors in order to compare both types of
markets in terms of the effective rate of interest.
4.1 Study Area
The study area was selected in such a way that there should be
representation of both rural and urban informal credit markets.
4.2. Rural informal credit markets
Informal credit markets function everywhere in the Punjab
irrespective of the distinction of place whether rural or urban; however for
the sake of the study the informal credit markets were segregated into rural
and urban markets in order to compare the different terms and conditions
prevailing in these markets. The following markets represent the typical
rural markets from where farmers purchase their farm inputs and sell their
farm produce. This includes the informal credit markets of:
1.
Samundri and Tandlianwala grain markets
2.
Khanewal/Multan peripheral areas
4.3. Urban informal credit markets
Informal credit markets also function in urban areas in different
forms, such as sale and purchase of different appliances, transport vehicles
on instalment basis and so on. The lenders believed that they were doing
their business without being involved in any kind of interest activity while
borrowers continued to participate in the informal lending market despite
being aware of the interest factor. So in order to explore the nature and
functioning of the urban informal credit markets, the following markets
were selected:
3.
Faisalabad Yarn Market
4.
Auto-rickshaw Market (Lytton road), Lahore
4.4. Sample Size
Because of the nature of the study - that is, a case study of
informal credit markets - the sample size was kept small. An effort was
made to include all the players of the informal credit market to the
maximum possible extent and to complete the linkages between them. The
total sample size was equalled 46 respondents, comprising moneylenders,
72
A Study of Informal Finance Markets in Pakistan
commission agents, input dealers, retailers and borrowers, etc.
4.5. Data collection approach
It was not possible to design a well-structured questionnaire in
order to explore and delineate all the dynamics of informal credit markets
because of the different natures of these markets. So, a separate semistructured questionnaire - a checklist of questions was framed for each
player of the informal credit market - was compiled which covered some
basic information as well as specific questions pertaining to the nature of
the role of each player in the informal credit market.
4.6. Data Collection
Due to the sensitive nature of the study, trained enumerators were
sent to collect data from the concerned players of the informal credit
markets. For this purpose three teams were constituted, one of which was
assigned the task of exploring the Faisalabad yarn market and the rural
informal credit markets in Tandlianwala and Samundri (district Faisalabad)
headed by a research economist, while the other two teams were assigned
the duty of obtaining data from the auto-rickshaw market representing the
urban informal credit market and rural informal credit market in the
Khanewal and Multan areas.
4.7. Sample size distribution
Table 1: Sample Size Distribution In The Study Area
Categories
Processing units
Moneylenders
Commission agents
Input dealers/retailers
Borrowers
Total
73
Samundri, Khanewal, Faisalabad
Tandlianwala Multan
2
1
3
3
3
3
5
3
4
4
3
13
17
6
Lahore Total
6
4
10
4
4
12
11
15
46
Results of case studies
Urban informal credit markets
5. Auto-rickshaw Market (Lytton Road, Lahore)
The auto-rickshaw market is a prominent example of an informal
credit market functioning in the urban area of the Punjab. In order to
understand the mechanism of the informal credit market in urban areas, an
exploratory survey of the market was conducted in which different market
players/actors were identified by the researchers: namely
dealers/commission agents, moneylenders, auto-rickshaw manufacturing
units, mechanics, buyers/purchasers and drivers who rent auto-rickshaws
on a daily wage basis. It became clear that moneylenders prefer to remain
behind the scenes for any deals between borrowers and commission
agents. Moreover, they were reluctant to meet borrowers in any form and
all their business was conducted by commission agents/dealers on their
behalf. Auto-rickshaw market functions, therefore, through commission
agents/dealers who act as commission agents as well as intermediaries
between the moneylender and the borrower. Clearly, the two parties that
could provide information about the functioning of these markets were
commission agents and the buyers/purchasers and the researchers thus
chose to interview them. While rickshaw drivers unhesitatingly answered
questions, the commission agents/dealers had to be sought as customers
in order to elicit the required information.
5.1. Key Market Players
There are four components of the auto-rickshaw market which
constitute the informal credit market. These are the moneylenders,
dealers/commission agents, sub-commission agents and borrowers.
5.2. Moneylenders
Generally, moneylenders are the backbone of the informal credit
market. They have links with the dealers/commission agents who function
in the market on their behalf. Although they are the main financiers in the
auto-rickshaw market, moneylenders prefer to remain in the background
of the business.
74
A Study of Informal Finance Markets in Pakistan
5.3. Commission Agents
Commission agents are the second important functionaries in the
auto-rickshaw credit market. They are the contact persons between the
moneylenders and the borrowers but do not arrange direct meetings
between the two. Agents act as middlemen and charge a commission for
the recovery of the credit amount. When asked, moneylenders did not
reveal whether the agents also charged them a commission.
5.4. Sub-commission Agents
Sub-commission agents have a dual function within the market:
primarily auto-rickshaw mechanics or drivers, they also convince
customers to deal with specific dealers/commission agents. For this
reason, their knowledge of the market proved particularly holistic. Once
they have brought the customer/borrower face to face with the
dealer/commission agent, they help the two parties reach an agreement. If
the deal is completed and the borrower purchases an auto-rickshaw, they
charge 500 rupees per deal from the dealer/commission agents. This fee is
added to the commission amount charged by commission agents from the
borrower.
5.5. Borrowers
The role of borrowers is as indispensable as the wheel of a vehicle
- after all, a vehicle is not a vehicle without locomotion. Moreover, like the
wheels of a vehicle, borrowers carry the entire burden of the market in the
sense that they bear all the costs being incurred.
5.6. Sample Respondents
Due to the nature of the study, two functionaries of the informal
credit market (auto-rickshaw market) were interviewed because they
provided the key information. Six dealers/commission agents and four
borrowers were selected for the interviews and the information provided
by the dealers/commission agents was cross-checked with that of the
borrowers.
75
5.7. Collateral Requirements
In response to the question of collateral requirements for
purchasing auto-rickshaw on a credit basis, both dealers/commission
agents and borrowers said that it was easy to purchase a rickshaw on credit
because unlike banks, dealers/commission agents do not take any physical
security/collateral. Only a photocopy of the national identity card and the
home address of the borrower (in case of house ownership) is the
necessary condition. But in case the borrower does not own a house, then
any of his relatives or friends can guarantee the responsibility of paying the
remaining instalments within the due time period.
5.8. Agreement
Routine procedure demands that commission agents make the
buyer sign an agreement which lists certain terms and conditions. The
researchers were able to obtain a copy of the agreement from the dealers in
order to ascertain these terms. For one thing, the agreement does not show
the buyer purchasing a rickshaw on credit but on the basis of rent, which is
usually fixed by the agent. Moreover, in case of non-payment of rent (the
name given by commission agents to instalments) the commission agent
has the right to confiscate the advance amount paid at the time of the deal
and the amount of instalments paid. The buyer is also told verbally that he
is purchasing the auto-rickshaw on instalments and is bound to pay the
monthly instalments in time; if he does not comply, his reputation will be
besmirched. Furthermore, in case non-compliance persists, the rickshaw
would be confiscated along with all the dues he has paid till further action is
taken by the commission agent.
During discussions with rickshaw drivers, the researchers found
that if the instalments have not been paid for three months, this agreement
is used as a justification to confiscate the auto-rickshaw. For the dealer, the
vehicle is hired on rent while the buyer assumes that he is purchasing the
rickshaw on instalment. The agent then deducts the total amount of rent
written in the agreement from the advance and the instalments paid by the
borrower and, if there is still some amount left to be paid, the buyer is
asked to pay those dues.
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A Study of Informal Finance Markets in Pakistan
5.9. Commission Fee
As mentioned above, the dealers/commission agents are the ones
who conduct the nuts and bolts of the business and charge a commission
from the buyers. According to rickshaw drivers, buyers have to pay a
commission fee - normally 3,000 rupees per rickshaw - over and above the
advance amount on the vehicle that is being bought on credit.
Furthermore, the auto-rickshaw mechanics or sub-commission agents are
also a liability on the borrower since they have to be paid 300 rupees per
rickshaw. This is because auto-rickshaw mechanics also act as agents to
dealers by bringing in customers for which they charge a commission,
usually 500 rupees per rickshaw.
One of the drivers said that if the advance amount is less than
15,000 rupees then the commission rate charged by the
dealers/commission agents came to 5,000 rupees per rickshaw. If the
advance totals more than 15,000 rupees, then the commission rate is 3,000
rupees per rickshaw. In case of no advance, which happens rarely with
sound collateral by a well-known person, the amount to be paid through
instalments is twice the cash price of the auto-rickshaw.
5.10. Interest Rate
The interest rate in the auto-rickshaw informal credit market
varies with different amounts of advance payment. The usual formula is
that if the remaining amount is less than 50,000 rupees after paying the
advance, then 50 per cent of the remainder is charged as interest over the
due period of credit or instalments. In cases where the remainder is more
than 50,000 rupees, more than 70 per cent of this is charged as interest over
the due period of the loan, normally extended over two to three years.
Information provided by dealers/commission agents revealed
that on an average, the interest rate being charged on the sale of autorickshaw on credit basis is 25.45 percent per annum. But when this figure
was cross-checked with the borrowers, the interest rate was calculated to
26.40 per cent per annum. The calculation of the effective interest rate
prevailing in the auto-rickshaw market includes the commission charges by
dealers, compensation to auto-rickshaw mechanics and the apparent
77
interest rate being charged along with instalments. There is a slight
difference between the effective interest rate calculated from the
information provided both by the dealers/commission agents and the
borrowers. Besides this interest rate, there is a danger of confiscation of
the rickshaw, the advance paid at the time of agreement and the monthly
instalments paid if the agreement written and signed between the two
parties is not complied with.
Sometimes these commission agents also furnish loans in the
form of cash on an interest basis while the documents of the autorickshaw or any other motor vehicle serve as collateral. In this case, the
interest charged is usually equal to 50 per cent of the amount borrowed
and the recovery procedure is identical to that of borrowing an autorickshaw.
5.11. Recovery Procedure
The credit amount is generally recovered through monthly
instalments, which equal 3,000 rupees. If payment on the instalment is late
by five or ten days, the commission agents do not impose a fine subject to
the prior intimation; indeed, two instalments can also be deposited as a
lump sum after informing the concerned dealer. But when three
consecutive instalments have not been paid, the auto-rickshaw is
confiscated. The confiscation procedure is initiated by circulating the
registration number of the vehicle in the market through different persons
who are also working on commission basis. After seizing the required
rickshaw, they inform the concerned dealer and receive 200 to 300 rupees
per rickshaw interned. Commission agents bear all the costs incurred on
this confiscation as well as the quarrels, if any, with the hired men. Then,
the borrower is given a one-month period to arrange the instalments he
owes. During this procedure, the personal preference of the dealer
determines the next step: whether he releases the auto-rickshaw after
receiving the due instalments or, according to the mutually agreed rent of
200 rupees per day, deducts the total amount of rent starting from the
beginning of the deal up to the date of handing over the rickshaw. This is
well within the rights of the commission agents because they have
evidence in black and white - i.e., the written agreement.
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A Study of Informal Finance Markets in Pakistan
5.12. Sources of Funds
During field visits, the researchers discovered that
dealers/commission agents work on behalf of a third party who invest
their money in this market. Since dealers were reluctant to give any
information about their business to any external person, the information
needed to be collected in the guise of customers. During discussions with
the dealers, the word “interest” was deliberately used by researchers in
order to gauge their viewpoint on the mark-up that they charge; it became
obvious that the commission agents did not believe they were exacting
interest. It can therefore be concluded that their financers would also be of
the same point of view. Borrowers intimately familiar with the market were
also consulted about the sources of the funds of dealers as well as
moneylenders, and they believed that financing is not obtained from banks
the market's financiers appear to have their own resources. Clearly, it seems
as if informal credit markets are an alternative to formal credit sources.
5.13. Rental Services
As mentioned above an agreement is written and signed by the
borrower at the time of deal with the dealers/commission agents. In that
deal the dealer/commission agent rents out his investor's auto-rickshaw to
the borrower at the rate of 200 rupees per day and the terms and
conditions regarding the payment of rent, maintenance, and traffic police
challans are mentioned in the agreement. In reality, this rental rate does not
prevail in the market; it exists only to be used by the dealer against the
borrower in case the agreement is not complied with in any way. Some
auto-rickshaw owners, however, also rent out to non-owners or drivers on
a daily basis. In this case there is wide variation in the rental rate depending
upon factors such as the condition (zero metre or second-hand), type
(CNG or Petrol), duration of hire (full-time or half-time) and so on. The
table below shows the different rental rates of auto-rickshaw prevailing in
the market.
79
Table 2: Rental Rates in the Auto-Rickshaw Market
Type of rickshaw
CNG
PETROL
Zero metre
Old (second-hand)
*Full time (Rs.) **Half-time Full time (Rs.) Half-time
(Rs.)
(Rs.)
160
140
150
130
140
120
120
110
* Full-time means 24 hours
** Half-time means only during the day
Moreover, the driver is responsible for any minor repair and
maintenance work totalling 50 rupees while the owner of the autorickshaw is responsible for major repair and maintenance work. All
additional expenditures incurred due to the fault of the rickshaw driver,
such as an illegal fee and a challan fee charged by the traffic police, are borne
by the drivers themselves.
Figure 1: Typical Informal Credit Market Mechanism (Lytton Road AutoRickshaw Market, Lahore)
Auto rickshaw
Manufacturers
Money Lender
Drivers
Dealer/Commission
age
Borrowers
Auto rickshaw Mechanics
Rickshaw Recovery Cell
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A Study of Informal Finance Markets in Pakistan
6. Faisalabad Yarn Market
The Faisalabad yarn market is also an example of a typical
informal credit market because business is conducted through oral deals
and informal credit in the form of kind, that is, cotton yarn, raw cloth and
so on. The textile business is heavily dependent on the yarn market and
several forward and backward linkages exist between the two. After
ginning factories purchase raw cotton from farmers through commission
agents and convert it into cotton lint, they sell this to yarn or spinning mills
which process the cotton lint into cotton yarn. The yarn is then bought by
big traders who sell the cotton yarn to retailers and weavers. In effect, raw
cloth is purchased by traders, sold to textile mills which perform the
finishing touches on the grey cloth and, finally, the finished cloth ends up
in the shops for use by the consumer. The entire business of the yarn and
grey cloth market rests on the credit mechanism - informal credit that is and payment in most cases is made through demand drafts which are
considered a more secure mode of transaction.
The smooth running of the textile business is contingent upon
the credibility of the market players. This is because they are reluctant to go
to formal lending institutions such as banks due to the difficulties faced by
borrowers in terms of documentation, complicated procedure, collateral
requirements and red tapism. Often, the hesitation also stems from a fear
of revealing business secrets. The above-mentioned factors lead the
business community to turn to informal credit sources which are more
readily available on easy terms compared to formal credit.
Formerly, yarn-producing mills had contacts with agency holders
to whom they used to sell their product on a credit basis and these agency
holders were responsible for the further sale of yarn. Now, however, yarnproducing mills are exclusively selling yarn on a net cash as well as credit
basis to well-established traders. Retailers and big traders can also purchase
yarn from these spinning mills. In Faisalabad, there are large numbers of
small weaving units which are working with retailers on credit. Payments
are usually made after one to three weeks going up to a maximum period of
30 to 35 days, and as the payment period increases, the rate of yarn - in
other words the interest rate - also increases. (But there is apparently no
81
interest involved in the eyes of the market players. They consider it a part
of business.) Moreover, the rate of interest also depends upon the quality
of yarn; other things remaining constant, the interest is low for low-quality
yarn and vice versa.
Brokers play an important role in any deal between sellers and
buyers: they have complete market information and facilitate an agreement
between both parties. For this service, brokers charge a commission which
is usually in terms of paisas per pound (in case of yarn) or metre (in case of
grey cloth). The figure below depicts the relationship between yarn quality
and interest rate.
Figure 2 : Interest Rate and Yarn Quality
The Faisalabad yarn market was explored by interviewing retailers
and weavers who are the ultimate buyers of yarn. Three retailers and three
weavers were selected for the interviews and the whole operation of the
business was discussed: from the terms and conditions of the trade, the
amount of profit charged by sellers to the mode of repayment. The
effective rate of interest when calculated on an annual basis ranges from
17.31 per cent to 46.15 per cent with an average figure of 28.39 per cent.
There are apparently no fixed rules and regulations in the yarn market to
sell the product on a cash or, if any, credit basis. Deals are usually
conducted between buyers and sellers, while weavers also sell their
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A Study of Informal Finance Markets in Pakistan
produce, grey cloth, to big traders on credit.
It was revealed to researchers during discussions that a few
moneylenders do invest their money in the yarn market. They disburse
loans after some preliminary investigations about the credibility of the
borrower and usually charge an interest of two to three per cent per
month. (Unfortunately, a meeting with these moneylenders could not be
held due to their unavailability at the time of the survey.) While some
moneylenders demand regular payment of interest and the principal
amount at the end, others recover their whole due amount at the end of the
stipulated period. In some cases the borrower also signs a written
agreement.
6.1. Recovery Procedure
Recovery is usually done after the due date, mostly in the form of
demand drafts. If the credibility of the borrower is well established in the
market, then there is some relaxation in the due period of the payment. For
wilful defaulters, the Yarn Market Association handles such cases though
social and legal pressures; if the borrowing party becomes bankrupt then
the association also conducts the sales of assets and gives the proceeds to
creditors according to the proportion of their amount defaulted.
7. Rural informal Credit Market
In the Punjab province, most farmers are small land-holders who
live from hand to mouth and depend on credit sources in order to fulfil
their agricultural and household consumption needs. In most cases their
credit sources are informal. Farmers suffer immensely from this vicious
circle of credit because at the time crops are sowed they obtain agricultural
inputs directly or indirectly from these informal sources and are also
bound to sell their produce through them. During this whole process of
borrowing and selling, farmers have to face exploitation in different forms
such as a low market rate for their produce, deduction of a commission fee
or a high interest rate in the form of greater prices of inputs than the
average market rate. Although farmers do have an alternate option in the
form of formal sources, they are afraid of the repercussions. Their social
circumstances are such that they are not willing to pledge their property,
83
fearing that if they are not in a position to pay back in time their property
would be confiscated. Moreover, the complicated procedures involved in
formal borrowing and the extra charges taken by bank officials are seen as a
hindrance. Farmers borrow from moneylenders, commission agents, input
dealers and even relatives and friends to fulfil their needs.
In order to procure complete information about the functioning
of such informal credit markets, different players of these markets were
interviewed. A brief description of each of these is as under:
7.1. Processing Units
Processing units working in the rural areas of Samundri,
Tandlianwala and Khanewal/Multan include cotton-ginning factories,
rice-husking mills (where is rice shelled) and poultry feed factories. These
processing units do not usually advance loans to farmers for the purchase
of inputs. Since the raw material used by these processing units is the
produce of the farmers, the owners of the units procure raw materials
through commission agents or directly from farmers.
7.1.1. Cotton-ginning factories
Cotton-ginning factories procure their raw material (raw cotton)
through commission agents and usually give them a one per cent
commission. The reason for such a low commission rate is justified by the
glut in the market at the time of harvesting/picking of the cotton crop.
7.1.2 Rice-husking mills
Rice-husking mills purchase raw materials from farmers as well as
from commission agents/dealers and beoparies on a net cash basis as well as
on credit. Rice mills usually purchase rice paddy from dealers/commission
agents on one-month credit and the typical rate of interest prevailing in the
market is about four per cent per month.
7.1.3. Poultry feed industry
Poultry feed mills procure their raw material from rural areas
through village beoparies and give them a 10 per cent commission on the
value of the raw material. When the poultry feed is ready to be sold, feed
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A Study of Informal Finance Markets in Pakistan
mills contact dealers who then sell the produce to poultry farms. Feed mills
usually give a seven per cent commission per bag of poultry feed to the
dealers and the dealers then sell on a net cash as well as credit basis.
Depending on their personal relations with borrowers, the size of
the poultry farm and the credibility of the poultry farmer, dealers
sometimes do not charge any interest rate for one week. In case of credit,
they usually issue a loan in kind for one and a half to three months which, if
calculated on an annual basis, amounts to a range of 36.5 to 40.90 per cent.
Poultry feed mills sometimes have contracts with poultry farm owners in
which the latter repay their loan in kind in the form of poultry eggs: in this
case, poultry farm owners subsidise their market rates for less than 35
rupees per box where one box contains 30 dozen eggs. The local poultry
market follows the Rawalpindi poultry market rates and purchases
products at a lower rate - 100 rupees per 30 dozen - than that prevailing in
Rawalpindi.
7.2. Moneylenders
7.2.1. Socio-economic characteristics
The socio-economic characteristics of moneylenders in rural
areas reveal that they are elderly people with an average age of 50 years and
belong to the farming community. An average land-holding size of six
acres indicates that they are not dependent on agriculture but have other
sources of income such as business, shopkeeping, or a portion of their
family savings from which they finance their moneylending business.
7.2.2. Preference while advancing loan and purpose of lending
Moneylenders were asked about whom they prefer to lend to.
Almost 38 per cent of the responses were in favour of businessmen, the
reason of which may be fewer chances of default, followed by 25 per cent
of responses in favour of agriculturists. When asked about why they
preferred to lend to relatives, they replied that they advance loans to
anyone whom they are confident will not default.
85
7.2.3. Loan advancement
Moneylenders usually advance loans after scrutinising borrowers
in order to avoid willful default. With an average number of 2.25 villages
under the ambit of the moneylenders, almost 75 per cent said that they
have some basic information about the credibility of the borrowers
because they belong to the same community. In such cases, their personal
experience of moneylending along with the market credibility of the
borrower come into play. Loans are advanced both in kind as well as cash:
indeed, a considerable proportion of moneylenders (25 per cent) revealed
that they advance loans against jewellery as collateral for a fixed period.
Almost 50 per cent of the moneylenders said that get the borrower to sign
an agreement - either on plain paper or an affidavit - which lists the terms
and conditions of the loan. The cost of the transaction, if any, is borne by
the borrower.
7.2.4. Heterogeneous nature of moneylending and interest rate
Moneylenders working in rural areas have differentiated their
money market with respect to the type of borrowers and have different
terms and conditions for each. For those with household and consumption
needs, they usually advance loans against some surety or a guarantor and
charge a very high interest rate; calculated in percentage terms, this
amounts to between 10 to 12.5 per cent per month. To businessmen and
agriculturists, on the other hand, moneylenders advance loans on soft term
at interest rate of one to 4.16 per cent per month. Irrespective of the type
of borrower, the average annual interest rate being charged by
moneylenders amounts to 55.2 per cent or 4.60 per cent per month.
The recovery procedure is also different for household and
business loans. A regular payment of interest is a pre-requisite of
consumption loans and the principal amount may be returned if the
borrower discontinues taking the loan. In agricultural/business loans,
however, the normal procedure is that repayment plus interest on the
borrowed amount is made at the completion of the sale of the produce
purchased with the borrowed funds. This takes usually two to three
months. Another difference is that if businessmen/agriculturists are not
able to repay their loans in time - for reasons such as a failure in business or
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A Study of Informal Finance Markets in Pakistan
the crop - moneylender wait a while for recovery, even perhaps till the next
crop season.
7.2.5. Actions taken against defaulters
Moneylenders require some guarantee or physical security such as
jewellery as collateral before they advance a loan, In case of noncompliance of the agreement, where the borrower does not pay back what
he owes within the stipulated period, 50 per cent of moneylenders
reported that they use social pressure as a tool to recover their due amount.
But sometimes when they have jewellery as collateral, they sell it and
deduct their loan amount from the sale. This is one of the extremes of the
actions taken by moneylenders against their defaulters.
7.2.6. Sources of funds
The moneylenders who were interviewed disclosed that they do
not depend on formal sources since their business operates on a limited
scale. Proof of the fact that they use personal funds raised through
business is that they manage their own accounts. Had their moneylending
business been on a larger scale, they would surely have hired someone to
manage their accounts. What is clear though is that none of the
moneylenders have horizontal links with each other: for instance, they do
not give credit to each other in order to expand their business.
7.3. Commission Agents
Commission agents play an important role in rural informal credit
markets because they have links with input dealers and farmers and
provide a meeting place in which to facilitate deals between buyers and
sellers. These commission agents also advance loans to farmers along with
selling their produce on a commission basis.
7.3.1. Socio-economic characteristics
Like moneylenders, commission agents also belong to the
agricultural community with an average land-holding size of 33.67 acres
and an average age of 46.3 years. Most commission agents were found to
be literate and their distribution with respect to education indicates that 50
87
per cent of them were matriculates followed by 16.67 and 33.33 per cent in
the graduate and intermediate categories. Although all the commission
agents possessed land, some also worked in other professional capacities;
the analysis shows that almost 34 per cent were teachers followed by timber
contractors, income tax officers, army servicemen and so on, each an equal
proportion of 16.66. Other agents are also involved in parallel business
activities - for instance, keeping a poultry or agricultural farm - which act as
a buffer for times when money is short or when borrowers default. On an
average, each commission agent has a roster of 65 customers on credit
basis scattered in seven villages.
7.3.2. Collateral requirement
As the business relations of commission agents and their
clients/farmers develop with the passage of time, so does the trust. This
leads to increased borrowing of agricultural inputs on a credit basis and the
selling of produce through the concerned commission agents. Moreover, a
guarantee from the borrower is must in case the latter is new in this market.
7.3.3. Commission fee and loan disbursement
Farmers usually bring their produce to these commission agents at
the end of the crop season when there is an opportunity for the purchase
and sale of commodities on which the agents receive their commission. In
the study area, commission agents usually charge an average percentage of
2.09 from farmers/sellers, whereas the range of commission is 0 to 3.15
per cent. In order to sustain their relationship with farmers, commission
agents apparently do not charge them a fee. Instead, they tack on the
amount to the price of the input at the time of its sale.
Commission agents are responsible for receiving payment from
the buyers of the farmer's produce and after deducting their commission
rate, if any, the remaining amount is returned to the farmers/sellers of the
commodities. With the passage of time, the role of these commission
agents increases and farmers start to take consumption as well as
production loans; the result is that farmers become dependent on the
agents to fulfil their credit needs due to increased input prices and low
prices come harvest time. Indeed, almost 84 per cent of commission
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A Study of Informal Finance Markets in Pakistan
agents reported that they issued loans to farmers in cash or kind. For loans
in kind, commission agents arrange agricultural inputs for their clients by
purchasing these from dealers on their own behalf and making payments
themselves after a week. In response, farmers are bound to bring their
produce to the commission agent from whom they borrowed inputs. It
was observed that as the expenditures of farmers increased they invented
new methods of fulfilling their credit needs by borrowing agricultural
inputs from one commission agent and selling to the other. Through this
method, they are able to extend the payback period. While some
commission agents have stopped issuing loans to farmers owing to this
behaviour, others have benefited as their business volume has increased.
7.3.4. Interest rate
Commission agents also charge an interest on the loans issued to
the farmers, with the rate being greater for pesticides than fertilisers. As
reported by commission agents, the interest rate amounts to 15.38 per cent
if calculated on an annual basis. When this figure was cross-checked with
borrowers/farmers, the interest rate drops a little to 12.57 per cent. But the
figure changes yet again - to 14.60 per cent per annum - if the sale and
purchase between the agents and farmers was taken into account.
7.3.5. Recovery procedure
Commission agents recover their loans when farmers bring their
produce to their commission shop. After deducting their due amount they
either return or retain the excess amount for a few days. In the latter case,
the agents do not pay any profit to farmers because they can be provided
this amount on demand at any time. As for the times when farmers are
unable to pay their loans in time due to crop failure or some other natural
calamities, commission agents have to wait perhaps for the next crop
season in order to recover the money they are owed.
7.3.6. Sources of funds
When asked about their sources of funds, commission agents
replied that they used their own finances without approaching banks or
other formal moneylending institutions. However, they utilise the
relationships they have with each other as well as moneylenders from
89
whom they borrow as the need arises. It can be therefore concluded that
informal markets are an alternative to formal money lending sources which
fulfils the credit requirements of farmers/borrowers.
7.4. Input Dealers
In the current era of modern agriculture, input dealers are
pivotally positioned in the agricultural input market because farmers have
to purchase most of their agricultural inputs from the market. Input
dealers also do business on a net cash as well as a credit basis. Farmers
either directly contact input dealers or go through their commission agents
for the purchase of agricultural inputs.
7.4.1. Socio-economic characteristics
Input dealers are mostly business-oriented people and it is not
necessary that they hail from the rural areas as is clear from the data which
reveals that 62.5 per cent of the input dealers own agricultural land with an
average figure of 40 acres. The percentage distribution of input dealers
with respect to education indicates that a maximum 37.5 per cent had
matriculated, 25 per cent had had eight years of education, an equal
percentage (12.5 per cent) were in the education groups of intermediate
and graduation, while 12.5 per cent were illiterate. Before starting the
business of informal credit, some had been in the same line such as
agricultural input dealers and pesticides salesmen, while others were in the
government or private service. Currently, the average number of
borrowers per input dealer is 76, most of which are in the cotton-wheat
zone of the Punjab province because of the pesticide business in this area.
The average number of villages where these input dealers conduct their
business was found to be nine.
7.4.2. Business procedure and interest rate
While input dealers usually sell agricultural inputs on cash, the
inputs can also be bought on credit. In the latter case, dealers charge an
additional price from the borrowers. Input dealers sometimes deal directly
with farmers but they generally prefer to sell inputs to farmers on behalf of
commission agents. In such situations commission agents - who receive
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A Study of Informal Finance Markets in Pakistan
their payment from farmers at the end of the crop season - pay dealers
themselves after a week or two.
Input dealers usually trade in pesticides/insecticides, fertilisers,
seeds and diesel in the rural areas. Different inputs are given on credit for
different periods of time and thus have different interest rates, but in order
to remove the difference in time period, they have been calculated on an
annual basis - the average rate being 25.81 per cent, while the range is
between 2.2 per cent to 74.2 per cent. The reason for such a low percentage
of interest is that there are some dealers who hawk more than one input to
one farmer and charge more on some - usually pesticides - while other
inputs such as fertilisers are sold on a no-profit-no-loss basis. In this way,
borrowers need only deal with one input dealer for all their requirements.
Usually input dealers prefer to give local or generic inputs on credit, mostly
in pesticides, because they receive more commission. The table below
shows the annual interest rate being charged by input dealers on different
inputs.
Table 3: Annual Interest Rate Being Charged by Input Dealers on
Different Inputs
Input category
Annual interest rate (%)
Fertiliser
4.02
Diesel
29.13
Pesticides
32.00
Poultry feed
40.91
Average
25.81
In order to cross-check the interest rate charged by input dealers
on different inputs, borrowers were also interviewed. On average
farmers/borrowers had to pay 38.97 per cent annual interest rate. But
when the information obtained from input dealers and borrowers was
combined, the annual percentage of interest rate charged on different
inputs was calculated as shown in the table below
91
Table 4: Interest Rate Being Charged Involving Input Dealers and their
Borrowers
Inputs
Annual interest rate (%)
Fertiliser
23.74
Pesticides
32.46
Diesel
29.13
Poultry feed
40.91
Average
29.75
The reason for the high interest charged on pesticides compared
to fertilisers is that it is used heavily on the cotton crop during the months
of June and October. Indeed, pesticides are booked in advance by pesticide
dealers and that means more commission. Input dealers then sell the prebooked pesticides to farmers on a cash or credit basis. Cash prices are
much lower than the maximum retail price written on the box of pesticides
because input dealers give up some of their commission in order to get a
rebate from pesticide companies owing to the increased volume sold
during peak season. For selling on credit basis, on the other hand, pesticide
dealers charge a certain amount over and above the maximum retail price.
The extent of mark-up being charged on pesticides depends on the nature
of the product being purchased (whether multinational or generic) and on
the relations between the borrower and the dealer. A study conducted by
Irfan et al, 1999, also calculated the interest rate as more for pesticides (35.2
per cent) than for fertilisers (18.6 per cent) on the basis of survey results,
while 29 per cent was on the basis of case studies.
Meanwhile, poultry feed dealers give inputs on credit for short
durations and for that purpose they charge an additional price. When
mark-up is therefore calculated on an annual basis, it amounts to more than
40 per cent.
7.4.3. Recovery procedure
Input dealers mostly recover their loan amount at the end of the
crop season through cash or kind as the case may be. In case of payment in
kind they take over the borrower's produce which they sell through
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A Study of Informal Finance Markets in Pakistan
commission agents. After deducting the commission fee and their due loan
amount, the excess amount is paid back to the farmer. While 44.45 per cent
of input dealers reported resorting to this method, only 11 per cent said
that they recover their loan through regular instalments, including interest
and principal.
7.4.4. Sources of funds
In response to the question about sources of funds, all the input
dealers reported that they financed their business with their own money
and had not borrowed from any formal or informal sources. When input
dealers were asked about the reasons why people borrow from informal
sources in spite of the existence of the formal sources which give loans at a
lower interest rate, the following reasons were quoted by the input dealers
as shown in the table below.
Table 5: Reasons for Preference Towards Informal Borrowing
Reasons
No documentation involved
Easy & quick availability
No collateral
Easy repayment
Low transaction cost
Total
Percentage of responses
26.09
34.78
26.09
8.70
4.35
100
7.5. Borrowers
Borrowers are the mainstay of the credit markets. The study of
exploring the credit markets would be incomplete if only the supply side
was considered. This is why it is important to investigate the demand
perspective as well in order to ascertain their point of view about the
functioning of such markets and the effective rate of interest being
charged by different suppliers of inputs on credit basis. For the current
study of rural informal credit market, eight borrowers of different
agricultural inputs were also interviewed.
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7.5.1. Socio-economic characteristics
It has been observed that borrowers are the resource-poor
segment of society whose expenditures exceed their income. In order to
even this disparity, they take loans from different sources as well as in
different forms - such as cash or kind - and have to bear the heavy cost of
such loans. Borrowers are poorly educated people as the study results show
that a majority (62.5 per cent) had had eight years of schooling, followed by
12.5 per cent in each of the primary, matric and intermediate education
categories. Seventy five percent of the borrowers possessed agricultural
lands with an average land-holding size of 14.92 acres. Out of eight
borrowers only two had borrowed in cash while the other six had
borrowed in kind in the form of agricultural inputs. During the survey it
was revealed that landless people borrow for consumption purposes from
moneylenders and have to pay a very high interest rate, a fact that the
survey results confirmed.
7.5.2. Collateral requirements
When borrowers were asked abut the collateral requirement for
obtaining loans, they revealed that as they had dealt with commission
agents and input dealers for a while, the personal relationships precluded
the need for collateral. People borrowing in cash from moneylenders said
that they presented social collateral for borrowing. In case of default,
borrowers reported that both commission agents and input dealers allow
some relaxation in payment to the extent of waiting for the next crop
season for genuine reasons.
7.5.3. Interestr Rate
The farming community takes two types of loans - in kind and in
cash - and informal credit suppliers charge different rates of interests on
both types. The average interest rate calculated on the basis of information
provided by these buyers amounted to 37.17 per cent per annum including
both types of credit. If the interest rate is bifurcated for credit in kind and
credit in cash, then the average figures are 29.81 and 85 per cent per annum
respectively. The detail of interest rates calculated on the basis of
information provided by borrowers is given in the table below:
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A Study of Informal Finance Markets in Pakistan
Table 6: Interest Rate Being Paid By Borrowers Of Informal Credit
Market On Different Inputs
Inputs
Fertilisers
Pesticides
Poultry feed
Borrowing in kind
Borrowing in cash
Overall average
Average annual interest rate (%)
26.86
31.62
36.52
29.81
85.00
37.17
Figure 3: Interest Rate by Type of Input and Type of Borrowing
7.5.4. Awareness and access to formal lending institutions
Borrowers were also asked whether they knew about formal
lending institutions such as banks, rural support programmes and so on
and almost 88 per cent reported that they were aware of them. But the
percentage of people borrowing from formal lending agencies was very
low, as only three persons (37.5 per cent) had borrowed from banks. It
seems as if there is some hindrance involved in borrowing from formal
lending institutions as is evidenced by the fact that a significant proportion
95
of respondents were aware of such agencies. When they were asked about
the reasons for not borrowing from existing formal credit sources, they
reported some difficulties/hurdles in the way of obtaining loans among
which are: collateral requirement (since a few farmer-tenants do not own
land), complicated procedures, non-cooperation of bank officials, time
consumption and delay in disbursement. On the other hand, informal
sources of credit provide credit without any physical collateral (only social
collateral), according to the requirement at the time of need and also to
tenants. Moreover, borrowers were of the view that informal credit was
more suitable because they are linked with informal lenders through their
business relations due to which repayment is made easier without the
cumbersome task of fulfilling documentation requirements.
7.5.5. Payment procedure
Almost 63 per cent of borrowers reported that they paid back the
credit amount including interest rate through cash while 37 per cent
returned the credit amount in kind. Twenty per cent of borrowers who
made payment in cash reported that they paid interest amount in
instalments while the principal amount was given at the end of the loan
period. And in case of in kind payment, the usual procedure is that farm
produce is sold through input dealers/commission agents and the
borrowed amount is deducted from the value of the produce while the
extra is returned to the borrower.
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A Study of Informal Finance Markets in Pakistan
References:
Irfan, M., G.M.Arif., S.Y. Ali and H.Nazli (1999). “The Structure of
Informal Credit in Pakistan”. Research Report No. 168. Pakistan Institute
of Development Economics.
Hussain, I and H.Demaine (1992). “How Informal Credit Offers Greater
Benefits to Farmers: An Enquiry into Rural Credit Markets in Pakistan”.
Division of Human Settlements Development, Asian Institute of
Technology, Bangkok, Thailand.
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